Why Are There Timeless Lessons That Do Not Get Arbitraged Away?
As shown in our December 2013 Advisor Perspectivesarticle, the history of public companies and their investment outcomes demonstrates how various styles of investing have worked over time. Strategies in which an investor buys shares in good companies mired in high pessimism (and therefore offered at low prices) bubble their way to the top in terms of persistent, long-term performance. By adhering to these types of contrarian or value-oriented strategies, investors can perform consistently and remarkably well across long periods.
No other strategy even comes close.
How could it be that the strong performance of contrarian-style strategies persists over time? One would expect that as the secret got out, more would convert to this style of investing and gradually compete away the opportunity for excess returns. Yet the secret has been out for a long time. Graham and Dodd wrote their seminal book on value investing 80 years ago. Since then, many studies have noted the persistent performance of value-oriented strategies, and the impressive track records of its practitioners have been impossible to ignore.
Nonetheless, the opportunity to generate solid long-term investment returns from these types of strategies endures.
Why does this persistent opportunity to outperform via value strategies exist? Should we expect it to continue to exist? Research in behavioral finance and our own Investment experience offer some answers.
Market prices are directly influenced by human behavior, because price is established by investment choices. Humans have many increasingly well-understood biases and cognitive flaws that result in predictable errors in how we evaluate investment opportunities.
It is not very interesting that humans can be “predictably irrational” (to borrow Dan Ariely’s phrase). If individual investors behave in uncorrelated ways, then individual misjudgments might cancel each other out, resulting in an efficient, wisdom-of-the-crowd market where price and value rarely diverge. However, such an efficient market is fantasy. It is not what we have observed in the historical record or encountered in our own investing.
Instead, we have witnessed investors collectively and repeatedly focusing on developments other than companies’ operating results. When investors do this, companies’ share prices and intrinsic values can materially diverge, creating opportunities to profit when price and value eventually reconvene. Therefore, of the many behavioral finance topics that explain why individual investors make bad decisions, we discuss a few that explain why investors often (mis)behave in the highly correlated manner required for great investment opportunities to emerge.