Previously, we discussed some of the empirical evidence for value investing. But why should this approach work in the first place? Isn’t the market efficient enough to eliminate opportunities for excess profit?
To answer these questions, it must first be acknowledged that the stock market is made up of market participants. And market participants are, after all, people.
Academic financial theory generally views people as descendants of Homo Economicus – that figurative human being who is characterized by the “infinite ability to make rational decisions”. Now, does the term infinitely rational accurately describe anybody you know?
In reality, most humans (including very smart ones) fall prey to all kinds of cognitive biases. Among the most costly of these is recency bias – the tendency to assume the future will be like the recent past.
In the late 1990s, many value-oriented money managers were trying to justify their aversion to profit-less technology stocks, even as those stock prices were soaring. The 1999 Sequoia Fund shareholder letter summarized the “new era” philosophy prevailing at the time:
“Rule 1) Any stock that has tripled during the past 12 months is a serious purchase candidate; and Rule 2) Any stock that has been flat for the past month or two or – God forbid – has gone down, is immediately sold.”
The mistake of extrapolating tech growth into infinity is a prime example of recency bias. Eventually, value managers were vindicated when the market remembered that it is important for companies to make money.
Another harmful behavior is stereotyping. In 2012, hedge fund manager Whitney Tilson surveyed investment professionals on reasons why they would not hold AIG stock. One response from a major mutual fund was “It might be a good investment but it could upset some current and potential investors if we were to own AIG.” In other words, the stigma attached to the name carried more weight in the investment process than the company’s actual prospects. Like recency bias, stereotyping is an emotionally-based predisposition, usually divorced from the relevant fundamentals.
We reject the academic premise that the market is made efficient by wealth-maximizing robots. Instead, we believe that human nature, imperfect as it may be, is one of the rare constants in investing. Those who recognize the hidden biases in others, and themselves, may stand to profit.
Aaron Pettersen, CFA, CFP®