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n our previous post on the subject of style investing we looked at the strange phenomenon known as the “value effect”, where over long time horizons so-called value stocks exhibit superior performance to growth stocks. We left that post with the question of why this is so – how can there be a systemic advantage to investing in this one particular style? In this post we will examine this question in more detail. For that we need to introduce two characters to help put these issues into context: Rational Man and Behavioral Woman. Here is the story of this odd couple.
For many decades now the conventional wisdom about investment decision-making has rested on the foundation of rationality. In this world (one comprised primarily of theoretical economists in their academic institutions) human beings possess complete, perfect knowledge about all possible current and future outcomes of any decision, and thus always make the ones that maximize their economic value. Among economists this is traditionally known as Rational Man Theory. In the world of investing Rational Man extends into a comprehensive theory for how markets work called the Efficient Markets Hypothesis (EMH). EMH states that, in addition to investors being the omniscient actors of the Rational Man Theory, markets themselves function perfectly and without friction. Prices adjust instantaneously to information as it becomes known, with the rational investors buying and selling based on complete knowledge about every single piece of information that could influence the value of every tradable asset.
How does this tale of Rational Man and EMH relate to the value effect? Well, according to the principles of EMH there cannot be a value effect. Everything material to a stock’s price is acted on within nanoseconds of becoming known, so prices follow a random walk up and down as each bit of data blips across the airwaves. There cannot be a systemic long-term advantage to investing in stocks with certain characteristics, like the low Price-to-Book attributes common to value stocks, because such an advantage would be immediately acted upon by rational investors and thus disappear – in finance-speak they would be “arbitraged away”.
Yet study after study upholds compelling evidence that the value effect exists, upending the wisdom that has held sway among financial practitioners for so many years. What gives? Enter the second character in our drama, Behavioral Woman.
Most people would look at the assumptions of rational economics and instinctively feel that they are off the mark as an explanation for how real humans make decisions. We’re not rational, we are quirky and most of the time cannot even clearly define what “value” actually means to us, let alone maximize it every time we make a decision. But as intuitive as that reasoning is, for a long time it was hard to turn Behavioral Woman into a well-reasoned explanatory theory about investing that could challenge Rational Man.
That started to change in the late 1970s and early 1980s with the research of two psychologists, Daniel Kahneman and Amos Tversky. Kahneman and Tversky methodically studied the way actual people go about making decisions and in so doing pioneered the discipline of behavioral economics (for which Kahneman won the 2002 Nobel Prize in Economics, Tversky having passed away some years before). Behavioral economics is a topic in and of itself (and probably deserves its own blog posting somewhere down the line) and with each increasingly intense and seemingly irrational boom-and-bust cycle we have witnessed over the past 15 years its adherents have grown in number.
The main point to make for purposes of this discussion is that many of the “errors” people commit when making economic decisions (read: making dumb choices) are not random but actually consistent and predictable. Kahneman and Tversky called these “heuristic errors” – think of these as shortcuts hardwired into the human brain that consistently trip up our best intentions to make smart decisions.
So how might Behavioral Woman offer us some insight into why the value effect exists? Well, by their very definition value stocks are underpriced companies that for some reason or other seem to be ignored by the market. There’s no “sexy story” about the typical value stock – it is the wallflower at the dance ignored by prospective suitors. The sex appeal in the world of investing usually falls to the growth stocks – think of the theatrical wizardry of Steve Jobs as he launches another worldbeating new technology, or the youthful exuberance of Google’s management team, or any shiny, new thing promising to revolutionize everything that matters in the world.
Sex appeal probably should have nothing to do with making smart financial choices – but actual human behavior tells us differently. Some Kahneman-Tversky acolyte may tell Behavioral Woman at a cocktail party that value stocks return more money than growth stocks over the long run, but her brain is just waiting to hear that loudmouthed guy swilling a gin & tonic boast about how he just “got in” on the newest thing that’s going to change the world forever. She should patiently invest in a value portfolio to get the best return over her time horizon, but her brain activates the shortcut trigger, panics that missing this hot growth stock will be losing the opportunity of a lifetime, and makes a decision more likely to result in tears than triumph.
The debate rages on – despite its many apparent flaws, rational economics has been in the mainstream of both theory and practice for too long to simply vanish from the public discourse. Meanwhile we still have the value effect, we know a lot more about the behavioral aspects of investing than we used to, and there are plenty of opportunities to use that knowledge…well…rationally!
