Simply by publishing an academic paper, a professor can demolish your investment strategy.
Buy stocks that recently did well, focus on firms that reinvest profits—it doesn’t matter. If a finance scholar writes about your strategy, over the next decade or so your returns will shrink by more than one-third.
That’s true for 82 different strategies that have been described in finance journals, say David McLean, a visiting associate professor of finance at the Massachusetts Institute of Technology’s Sloan School of Management, and Jeffrey Pontiff, a professor of finance at Boston College. The duo describe their findings in a working paper that has been presented at several finance conferences this year, most recently at the University of Luxembourg. Its title: “Does Academic Research Destroy Stock Return Predictability?” The answer: Yes.
“We looked at strategies analyzed in 68 different papers,” says McLean. “When we compared the performance of the sample of stocks used in the paper to those stocks postpublication, traded with the same investment strategy, we saw a decline of 35 percent, on average. That means that if your strategy was growing your portfolio at 1 percent every month before the paper was published, it dropped to 0.65 percent after publication.”
What’s happening, McLean believes, is that savvy investors read those articles and start to use the strategies. So one result is that a stock becomes more in demand, raising its price, and that cuts into future profits of people who buy it.
His evidence? “Once a paper was published, we saw more trading activity in the stocks used in the original sample, or similar stocks. There was a lot more volatility.” And the decline was biggest in stocks that were easiest to trade, such as those of big companies like General Electric that have lots of shares at modest prices. So it was simple for investors to try strategies using those stocks. The stocks of tiny, new companies that are hard to get hold of showed smaller declines.
McLean and Pontiff culled the strategies from finance, accounting, and economics publications like Financial Analysts Journal. The strategies worked as described during the time period when the stock sample occurred. They also worked, more or less, after the sample period ended and before the paper was published. After publication, though, their performance saw that large drop.
It is possible that some of the 82 strategies simply identified risky stocks that would eventually drop even if a paper had not been published. That’s a point that critics have raised when the researchers have presented their findings, McLean says. But he’s dubious, noting that risky stocks should show a severe decline in the prepublication periods he and Pontiff studied, but they don’t.
“Once you draw attention to a strategy, then it stops working as well,” McLean says. Essentially, academics are helping the markets work, drawing attention to stocks that are overpriced or underpriced. Then the market, in a way that will please traditional economists, moves to correct those values.
This can have effects within the university, too, McLean adds. “If a dean asks a professor of finance, ‘Does your work have any relevance for the real world?,’ the professor can point to our paper and say, ‘Yes, I guess it does.’”
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