Is it possible to measure the value of fundamental investment research? How does the degree of measurability affect the behaviors of investors and financial markets? In the June 2009 version of his paper entitled “Investment Research: How Much is Enough?”, Bradford Cornell speculates on answers to these questions. Citing a range of research on mutual fund research practices and performance, he concludes that:
- Given the noisy stochastic nature of stock returns, the vast number of approaches to investment research and the likelihood that the results for any particular research approach change over time, statistical inference regarding the value of fundamental investment research is essentially worthless.
- To measure the return on research, one must first reliably measure investment returns. Forty years of academic research comprised of hundreds of studies has failed to find consistent, meaningful evidence that: (1) the mutual fund industry beats the market; and, (2) the outperformance of any individual mutual funds is attributable to skill and not luck. Some studies find weak evidence of fund outperformance persistence; others do not. How could one therefore conclude that the contribution of associated research is materially different from zero?
- The return on fundamental investment research is likely not constant for an investment company or even for an individual because the information sources, research methods and areas of research emphasis are dynamic.
- Assuming normality of return distributions, confident identification of superior performance on the order of 3% per year for diversified portfolios (individual securities) requires a sample duration of about five (100) years. For individual securities, confident inference regarding an extreme annual alpha of 10% requires 10 years of data. Measurements of the return on fundamental investment research are therefore generally of very low confidence.
- Low confidence in measurements of the value of fundamental research forces an investor to rely substantially on judgment, gut instinct and (if selling advisory/management services) marketing considerations in choosing research methods and setting levels of investment in research.
- Research strategies chosen on the basis of nebulous judgments and gut instincts are fragile compared to those based confidently on reliable scientific evidence.
- Sustained/dramatic market movements that undermine confidence in these judgments and gut instincts can therefore trigger a positive feedback loop between asset price volatility and investment research decisions. For example, an unexpected plunge in asset prices causes some investors to abandon their research outputs (valuation estimates) and liquidate their positions, thereby further depressing prices and causing more investors to abandon their research outputs. The resulting crash in asset prices would not occur if investors had confidence in their research.
In summary, investors should recognize the difficulty of measuring the value of fundamental investment research in deciding whether or how much to spend for it.
Non-normality of returns further confounds reliable measurement of investing performance and therefore of the value of fundamental investment research.
