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“…Using monthly data stretching back more than four decades, we find that the average (annualized) monthly return of the extreme growth portfolio is about 3.8 percent. Instead the average (annualized) monthly return of the extreme value portfolio is a whopping 10.9 percent. Thus, on average, value stocks earn a nice 7.1 percent annualized monthly return over growth. Academics call that 7.1 percent the value premium.

When academics find a premium, any premium, the first question they ask themselves is: Why does this particular strategy or portfolio command such a premium? Or to put it differently: What is the source of risk embedded in value stocks that requires compensation in the form of large returns if these stocks are to be held by investors? And if risk cannot explain it, what can?

…the CAPM (a model that prescribes what portfolio returns should look like for a given amount of risk) says that value stocks should have much lower returns than what they have in the data! The inability of the CAPM to explain the value premium is what academics call the value premium puzzle. Many of the debates in academia can be understood simply by following where people stand on the lessons one can draw from this plot.

…This debate is endless for profound reasons. Indeed, the inability to distinguish between whether the CAPM is a good model of risk and mispricing is such an important feature of the debate that academics have given it a name, somewhat pedantically: the joint hypothesis problem. In layman’s terms: When you see alpha, are you mismeasuring risk or finding value? This debate is at the heart of modern finance.”

Readers know where I stand on this issue, however. Read the whole thing:

http://www4.gsb.columbia.edu/ideasatwork/feature/7317821

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