How Human Behavior may Lead to a Persistent Edge for Value Investors
Many believe that there can be no permanent edge in investing because they believe that market forces will quickly eliminate any edge. That is, many believe that sophisticated investors will bid up prices in investment strategies that tend to outperform and bid down prices in strategies that tend to lag until the edge disappears.
For my first post on this blog, I will write about a persistent investing edge–value investing–and one reason why that edge may never disappear; that reason being human behavior, which rarely changes. We can thank Jason Zweig (Your Money and Your Brain) and James Montier (Behavioural Investing) for describing in their books the behavioral experiment described in this post.
The Persistence of Value Investing’s Edge
There are many academic studies that demonstrate that value investing beats glamour investingin the long run; see, for example, Fama and French (F&F)or Lakonishok, Shleifer and Vishny (LSV) or the many studies that built on F&F’s original research and examined performance data going back to the 1920s.
Besides academic studies, we have many examples of practicing value investors who have grown wealthy by consistently beating the market in the long run—from Benjamin Graham to Warren Buffett (before his capital grew to an enormous size) to David Einhorn. Conversely, we have few examples of glamour investors who have consistently beaten the market.
As for the academics, Fama and French also happen to be, as James Montier likes to say, two of the “High Priests” of the Efficient Market Hypothesis (EMH). Their concession that value beats glamour is even more remarkable because the EMH implies that all such edges must disappear. If value investing offers superior returns, then the EMH also implies that value stocks must be riskier than glamour stocks, but we shall show in another post that in the long run value investing is actually safer than all other equity investing styles.
What may be most remarkable about the F&F story is that these two high priests of the EMH later became integral partners at Dimensional Fund Advisors (DFA), which is a $130 billion-plus fund firm that attempts to beat the market. In fact, according to the DFA video below, DFA as we know it would never have been possible without F&F’s research on the persistent success of value investing. And, DFA was not the only firm built on this analysis. The firm LSV–yes, the same LSV as above–currently runs over $30 billion in assets based on the value-investing principles they discovered in their academic research.
Why isn’t Every Investor a Value Investor?
So all of this begs the question: If value almost always outperforms in the long run and is almost always less risky in the long run, then why aren’t all investors value investors? Part of the answer appears to lie in human evolution and its mark on our behavior; behavior that makes it difficult to execute a value-investing strategy.
The field of behavioral economics and finance arose in the last half of the last century. It evolved from the outcomes of experiments that revealed how people actually behaved in different environments. In that regard, it developed unlike traditional economic theory, which was created by economists who simply assumed that humans behaved rationally almost all of the time. Traditional economic theorists then went about creating precise mathematical models to prescribe policy for rational beings. I agree that in a world of perfectly rational behavior, almost all investing edges should disappear.
I also agree that if everyone acted rationally and processed readily available information the way the theorists supposed, there would be few obese people in the United States. We all know that we need to eat right and exercise in order to look our best and postpone pain, debilitating disease, and death. The rational thing to do in that case is eat right and exercise. But, somewhere between the theorists’ expectations and the outcome, our behavior fails us.
Pigeons versus Humans
So, consider the following expirement which may explain one of our behavioral flaws: Pigeons and rats are shown flashing lights—one red and one green. Eighty percent of the time the light flashes green, and 20% of the time red, but they flash in a random order. When the animals guess the next flash correctly they are rewarded with a morsel of food. Rats and pigeons figure out fairly quickly that it is best to predict a green flash every time because when they do they are rewarded 80% of the time.
We humans, on the other hand, have been programmed in our evolution to look for patterns. Even when we are told explicitly that the flashes of light are random we still believe we can discern a pattern and predict the next red flash. Humans in this experiment tend to guess that the next color that will flash will be red approximately 20% of the time. That behavior leads to a virtual certainty that humans will do worse than the pigeons in this experiment. For the pigeon, the probability of guessing the correct color flash is 80%; for humans it is only 68%. Eighty percent of the time humans will guess green and eighty percent of those times they will be correct; twenty percent of the time they guess red and twenty percent of those times they will be correct (0.8 * 0.8 + 0.2 * 0.2 = 0.68).
This is one possible answer to why so few investors are true value investors despite the obvious success of the strategy over long periods of time. Markets are complex and when examined over short periods they seem to deliver random results—up one day and down the next. And, value strategies will not outperform in each and every period. One can make the analogy that investing is like the light flash experiment: value investing is a green flash that “wins” far more often than the red flash (glamour investing), but we humans will still occasionally move capital to glamour strategies because we believe we can discern a pattern and so we try to predict the next time that glamour will beat value.
This, of course, is not the only behavioral reason that there are few true value investors; our emotions often get the best of us. And there are cognitive and institutional constraints, too, that aid in maintaining value’s performance edge. We will try to cover them here on this blog. I hope you enjoy reading about them as much as I do.
Jason Zweig makes the following important points about our attempts to divine patterns in random results, which he calls our prediction addiction: 
It is vital to recognize the basic realities of pattern recognition in your investing brain:
- It leaps to conclusions. Two in a row of almost anything—rising or falling stock prices, high or low mutual fund returns—will make you expect a third.
- It is unconscious. Even if you think you are fully engaged in some kind of sophisticated analysis, your pattern-seeking machinery may well guide you to a much more instinctive solution.
- It is automatic. Whenever you are confronted with anything random, you will search for patterns within it. It’s how your brain was built.
- It is uncontrollable. You can’t turn this kind of processing off or make it go away.
I think it would be useful to study the brains of great value investors like Buffett to determine if their pattern recognition programming is more subdued than others. If so, it may be that great investors are born and not made.
True value investors like Buffett are the stubborn pigeons whose research has determined that buying with a margin of safety wins more often than it loses—and that when it wins it tends to win by a lot. They stick with their strategy and processes regardless of the vicissitudes of the market, and in the long run they trounce all other investors and indexes. Market timers believe they can guess the next market move, but will almost certainly fall short. Value investors are few in number for a variety of behavioral, cognitive, and institutional reasons, one of which is our brains’ inability to tune out spurious pattern recognition.
 Like LSV, we use the term glamour instead of growth because all value investors desire growth; it is just that they are rarely willing to pay as much for that growth as the rest of the market. Glamour connotes a spurious value, which makes it more appropriate to contrast with true value.
 1992, “The Cross-Section of Expected Stock Returns,” Journal of Finance, vol, 47, no. 2 (June): 427-465.
1994, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance, vol, 49, no. 5 (December): 1541-78.
Zweig; Your Money and Your Brain; p. 61