The demise of empiricism.
The clash between the 3-factor model and the q-factor model is a clash between two philosophies of science and two visions for the future of asset pricing. And an epic struggle for its soul.
The 3-factor model is a product of empiricism. This philosophy of science dates back to David Hume in the 18th century, arises as logical positivism of the Vienna Circle in the 1930s, and modifies as logical empiricism in the 1950s and 1960s.
Empiricism is built on the verification principle, which insists that all scientifically meaningful statements must be verifiable (testable) with our senses, facts, and data. The verification principle emphatically rejects metaphysics, including theories of causation beyond Hume’s constant conjunctions (correlations).
After reaching its heyday in the 1960s, philosophers today generally regard empiricism as defunct. Most tellingly, the verification principle itself is not verifiable, meaning that it is itself an unfalsifiable metaphysical presupposition. Oops. As far as philosophy goes, this defect is insurmountable... All in all, theory is indispensable.
In asset pricing, empiricism has also crashed to the ground, albeit only recently.
The 6-factor paper states (2018, p. 237): “We include momentum factors (somewhat reluctantly) now to satisfy insistent popular demand. We worry, however, that opening the game to factors that seem empirically robust but lack theoretical motivation has a destructive downside: the end of discipline that produces parsimonious models and the beginning of a dark age of data dredging that produces a long list of factors with little hope of sifting through them in a statistically reliable way (my emphasis).”
Seriously? The beginning of a dark age? Isn’t it really the end of the dark age ushered in by the 3-factor paper in 1993? The q-factor model published in 2015 has ended the dark age. And the 6-factor paper merely confirms the end of the dark age via a form of doublespeak.
The creation of the q-factor model is an imaginative, retroductive, and iterative fusion between asset pricing theory and asset pricing empirics. The q-factor model asks: What the fundamental structure of capital markets must be like for us to observe asset pricing anomalies? The starting point is theoretical (transcendental). After I identify the causal powers of investment and profitability in 2005, it then takes another 10 years to put the empirics together. Contrary to Hume’s induction, the scientific inference is retroduction (closely related to abduction, i.e., inference to the best explanation).
Far from Hume’s empiricism, the philosophy of science embodied in the q-factor model is Roy Bhaskar’s critical realism. In addition to the domain of the empirical (observed events, the only reality accepted in empiricism), critical realism also allows the domain of the real (causal powers, causal structures, and causal mechanisms).
All in all, theory plays an important, if not major, role in science. About time to take causation seriously in asset pricing.
If the 3-factor model is like the alpha variant of Covid-19, the 5-factor model would be the delta variant, and the 6-factor model the wimpy delta+. While Covid-19 infects our lungs, the 3-factor virus eats our brains and turns us into zombies, who refuse to dig any deeper than observed events and even actively deny the need of doing so. As evidenced by the quote above from the 6-factor paper about "popular demand," the 3-factor virus has turned our beloved science into a dystopian Oceania.
The q-factor model is like the Pfizer vaccine. It borrows the factor form from the 3-factor virus but neutralizes its rotten, poisonous core of defunct empiricism. And the expected growth factor is our booster.
I have no conflicts of interest to declare. My only objective in life is the pursuit of scientific knowledge. The state of Ohio couldn’t care less about whether my results come out one way or another. And I couldn’t care less about any investment company’s assets under management.
Truth is fragile. Freedom is not free.
To protect ourselves from the delta surge, please consider taking the vaccine to ensure a brighter future.
Please see my latest interview below with Jack Forehand and Justin Carbonneau on my recent adventure into philosophy of science in the context of scientific debates within asset pricing.