Bailey and Lopez de Prado on the crisis of pseudoscience in finance

In a 25 May 2018 Forbes article, Brett Steenbarger interviews David H. Bailey and Marcos Lopez de Prado on the growing crisis of pseudoscience in finance.

Here is an excerpt:

Imagine that a pharmaceutical company develops 1000 drugs and tests these on 1000 groups of volunteer patients. When a few dozen of the tests prove “significant” at the .05 level of chance, those medications are marketed as proven remedies. Believing the “scientific tests”, patients flock to the new wonder drugs, only to find that their conditions become worse as the medications don’t deliver the expected benefit. Some consumers become quite ill and several die.

Clearly, there would be a public outcry over such deceptive practice. Indeed, that is precisely the reason we have a regulatory agency and laws to help ensure that medications have been properly tested before they are offered to the public. According to Marcos Lopez de Prado, no such protections are offered to financial consumers, leaving them vulnerable to unproven investment strategies. …

Nor is this crisis limited to the world of quantitative finance. David H. Bailey, in a post to the Mathematical Investor site, points to a wide range of financial providers, from banks to brokerages, that promote untested, unproven technical analysis strategies. These encourage traders and investors to put their money to work, while offering guidance with no objective information value. Indeed, Bailey and Lopez de Prado note that the most important plot in finance is not a technical analysis pattern, but a statistical distribution of Sharpe Ratios as a function of the number of backtests conducted. If one looks at enough combinations, it is quite possible to find technical patterns that will achieve seemingly astronomical risk-adjusted returns. The great majority of these are spurious.

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