False (and Missed) Discoveries in Financial Economics |
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| Authors: | CAMPBELL R. HARVEY YAN LIU |
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| Affiliation: | 1. Correspondence: Campbell Harvey, Duke University and National Bureau of Economic Research;2. e-mail: cam.harvey@duke.edu;3. Campbell R. Harvey is with Duke University and National Bureau of Economic Research. Yan Liu is with Purdue University. We appreciate the comments of Stefan Nagel;4. two anonymous referees;5. as well as Laurent Barras, Claude Erb, Juhani Linnainmaa, and Michael Weber;6. and seminar participants at Rice University, University of Southern California, University of Michigan, University of California at Irvine, Hanken School of Economics, Man-Numeric;7. Research Affiliates;8. and the 2018 Western Finance Association meetings in San Diego. Kay Jaitly provided editorial 9. assistance. The authors do not have any potential conflicts of interest, as identified in the JF Disclosure Policy. |
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| Abstract: | Multiple testing plagues many important questions in finance such as fund and factor selection. We propose a new way to calibrate both Type I and Type II errors. Next, using a double-bootstrap method, we establish a t-statistic hurdle that is associated with a specific false discovery rate (e.g., 5%). We also establish a hurdle that is associated with a certain acceptable ratio of misses to false discoveries (Type II error scaled by Type I error), which effectively allows for differential costs of the two types of mistakes. Evaluating current methods, we find that they lack power to detect outperforming managers. |
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