What Is a Null Hypothesis?
A null hypothesis is a type of statistical hypothesis that proposes that no statistical significance exists in a set of given observations. Hypothesis testing is used to assess the credibility of a hypothesis by using sample data. Sometimes referred to simply as the "null," it is represented as H0.
The null hypothesis, also known as the conjecture, is used in quantitative analysis to test theories about markets, investing strategies, or economies to decide if an idea is true or false.
- A null hypothesis is a type of conjecture in statistics that proposes that there is no difference between certain characteristics of a population or data-generating process.
- The alternative hypothesis proposes that there is a difference.
- Hypothesis testing provides a method to reject a null hypothesis within a certain confidence level.
- If you can reject the null hypothesis, it provides support for the alternative hypothesis.
- Null hypothesis testing is the basis of the principle of falsification in science.
How a Null Hypothesis Works
A null hypothesis is a type of conjecture in statistics that proposes that there is no difference between certain characteristics of a population or data-generating process. For example, a gambler may be interested in whether a game of chance is fair. If it is fair, then the expected earnings per play come to zero for both players. If the game is not fair, then the expected earnings are positive for one player and negative for the other. To test whether the game is fair, the gambler collects earnings data from many repetitions of the game, calculates the average earnings from these data, then tests the null hypothesis that the expected earnings are not different from zero.
If the average earnings from the sample data are sufficiently far from zero, then the gambler will reject the null hypothesis and conclude the alternative hypothesis—namely, that the expected earnings per play are different from zero. If the average earnings from the sample data are near zero, then the gambler will not reject the null hypothesis, concluding instead that the difference between the average from the data and zero is explainable by chance alone.
The null hypothesis assumes that any kind of difference between the chosen characteristics that you see in a set of data is due to chance. For example, if the expected earnings for the gambling game are truly equal to zero, then any difference between the average earnings in the data and zero is due to chance.
Analysts look to reject the null hypothesis because doing so is a strong conclusion. This requires strong evidence in the form of an observed difference that is too large to be explained solely by chance. Failing to reject the null hypothesis—that the results are explainable by chance alone—is a weak conclusion because it allows that factors other than chance may be at work but may not be strong enough for the statistical test to detect them.
A null hypothesis can only be rejected, not proven.
The Alternative Hypothesis
An important point to note is that we are testing the null hypothesis because there is an element of doubt about its validity. Whatever information that is against the stated null hypothesis is captured in the alternative (alternate) hypothesis (H1).
For the above examples, the alternative hypothesis would be:
- Students score an average that is not equal to seven.
- The mean annual return of the mutual fund is not equal to 8% per year.
In other words, the alternative hypothesis is a direct contradiction of the null hypothesis.
Examples of a Null Hypothesis
Here is a simple example: A school principal claims that students in her school score an average of seven out of 10 in exams. The null hypothesis is that the population mean is 7.0. To test this null hypothesis, we record marks of, say, 30 students (sample) from the entire student population of the school (say 300) and calculate the mean of that sample.
We can then compare the (calculated) sample mean to the (hypothesized) population mean of 7.0 and attempt to reject the null hypothesis. (The null hypothesis here—that the population mean is 7.0—cannot be proved using the sample data. It can only be rejected.)
Take another example: The annual return of a particular mutual fund is claimed to be 8%. Assume that a mutual fund has been in existence for 20 years. The null hypothesis is that the mean return is 8% for the mutual fund. We take a random sample of annual returns of the mutual fund for, say, five years (sample) and calculate the sample mean. We then compare the (calculated) sample mean to the (claimed) population mean (8%) to test the null hypothesis.
For the above examples, null hypotheses are:
- Example A: Students in the school score an average of seven out of 10 in exams.
- Example B: Mean annual return of the mutual fund is 8% per year.
For the purposes of determining whether to reject the null hypothesis, the null hypothesis (abbreviated H0) is assumed, for the sake of argument, to be true. Then the likely range of possible values of the calculated statistic (e.g., the average score on 30 students’ tests) is determined under this presumption (e.g., the range of plausible averages might range from 6.2 to 7.8 if the population mean is 7.0). Then, if the sample average is outside of this range, the null hypothesis is rejected. Otherwise, the difference is said to be “explainable by chance alone,” being within the range that is determined by chance alone.
How Null Hypothesis Testing Is Used in Investments
As an example related to financial markets, assume Alice sees that her investment strategy produces higher average returns than simply buying and holding a stock. The null hypothesis states that there is no difference between the two average returns, and Alice is inclined to believe this until she can conclude contradictory results.
Refuting the null hypothesis would require showing statistical significance, which can be found by a variety of tests. The alternative hypothesis would state that the investment strategy has a higher average return than a traditional buy-and-hold strategy.
One tool that can determine the statistical significance of the results is the p-value. A p-value represents the probability that a difference as large or larger than the observed difference between the two average returns could occur solely by chance.
A p-value that is less than or equal to 0.05 often indicates whether there is evidence against the null hypothesis. If Alice conducts one of these tests, such as a test using the normal model, resulting in a significant difference between her returns and the buy-and-hold returns (the p-value is less than or equal to 0.05), she can then reject the null hypothesis and conclude the alternative hypothesis.
How Is the Null Hypothesis Identified?
The analyst or researcher establishes a null hypothesis based on the research question or problem that they are trying to answer. Depending on the question, the null may be identified differently. For example, if the question is simply whether an effect exists (e.g., does X influence Y?) the null hypothesis could be H0: X = 0. If the question is instead, is X the same as Y, the H0 would be X = Y. If it is that the effect of X on Y is positive, H0 would be X > 0. If the resulting analysis shows an effect that is statistically significantly different from zero, the null can be rejected.
How Is Null Hypothesis Used in Finance?
In finance, a null hypothesis is used in quantitative analysis. A null hypothesis tests the premise of an investing strategy, the markets, or an economy to determine if it is true or false. For instance, an analyst may want to see if two stocks, ABC and XYZ, are closely correlated. The null hypothesis would be ABC ≠ XYZ.
How Are Statistical Hypotheses Tested?
Statistical hypotheses are tested by a four-step process. The first step is for the analyst to state the two hypotheses so that only one can be right. The next step is to formulate an analysis plan, which outlines how the data will be evaluated. The third step is to carry out the plan and physically analyze the sample data. The fourth and final step is to analyze the results and either reject the null hypothesis or claim that the observed differences are explainable by chance alone.
What Is an Alternative Hypothesis?
An alternative hypothesis is a direct contradiction of a null hypothesis. This means that if one of the two hypotheses is true, the other is false.