There’s a lot of talk in the media about “low-information” voters. Ted Cruz may be responsible for coining the term. He referred to supporters of Donald Trump as those “who have relatively low information, who are not that engaged and who are angry.” He observed that other candidates are beating Trump “when voters get more engaged and they get more informed.”
The danger of “low information”
I see a parallel between the worlds of politics and investing. The securities industry preys on “low-information” investors who don’t know the underlying data. These investors are inundated by pundits, analysts and other “financial pros” who claim the ability to pick outperforming stocks, time the markets and identify the next “hot” mutual fund or alternative investment. When investors get “more engaged” and “more informed,” they understand that efforts to “beat the market” simply enrich brokers while likely causing them to underperform comparable index funds.
“High-information” investors are taking action
“High-information” investors understand this reality: It’s not that it is impossible to “beat the market.” Rather, it’s that the odds of doing so are so small it makes no sense to try. It’s for this reason that,according to Morningstar, “investors added $361.8 billion to all passively managed stock and bond funds in the U.S. in the first 11 months of 2015, while pulling $139.5 billion from actively managed funds.”
Misleading arguments for active management
I recently heard a broker make a very clever argument for active management, which was geared to take advantage of a certain lack of sophistication among some investors. Here’s what he said: “If you invest in index funds, 100 percent of those funds will underperform their benchmark index. With active management, you know that at least some funds will outperform the index.”
This statement is technically true, but fundamentally misleading. You can’t buy the index. But you can purchase funds that track the index. Doing so incurs a management fee. As a result, investors earn the return of the index less this fee. Therefore, all index funds will underperform the index.
However, because many index funds charge very low fees, the majority of actively managed funds underperform both their benchmark index and index funds tracking that index.
Active management vs. index funds
My colleague, Larry Swedroe, recently analyzed the performance of actively managed funds that attempted to beat different indexes. He compared this performance to comparable index funds managed by Vanguard (and not to the index). Here’s what he found for the 10-year period from 2006 through 2015:
Lack of persistence
To beat the returns of these index funds, your broker would have to identify the small minority of actively managed funds likely to outperform them prospectively. This is an exceedingly difficult task. According to an analysis by Standard & Poor’s, only 7.48 percent of large-cap funds, 3.06 percent of mid-cap funds and 7.43 percent of small-cap funds maintained top-half performance over five consecutive 12-month periods.
Think about this data for a moment. If your broker claims the ability to pick an outperforming mutual fund, ask for details on the methodology he or she is using. If you are told the methodology is past performance, you know this can’t be right. There’s an inverse relationship between past and future performance.
Become an evidence-based investor
If you understand the low odds of picking an outperforming actively managed fund over the long term, as well as the lack of persistence among the funds that do outperform, you’ve made a giant leap toward transitioning from a low-information to a high-information investor.
Now fire your “market-beating” broker and become an evidence-based investor.
This commentary originally appeared March 22 on HuffingtonPost.com
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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
There’s very strong historical evidence to support the existence of a value premium in equity markets. While there’s no dispute over the existence of the value premium (value stocks have provided an annual average return 5% higher than growth stocks over the long term), there is much debate over the cause of the difference in returns.
In one camp are financial economists who argue that the value premium is a risk story—value stocks are riskier than growth stocks. As a result, investors must be compensated in the form of higher expected returns. Others argue for an alternative explanation—there’s a persistent overvaluation of the earnings prospects for growth stocks. And what’s more, there’s a wealth of evidence on both sides.
The Allure Of Growth
Keith Anderson and Tomasz Zastawniak—authors of the October 2015 study “Glamour, Value and Anchoring on the Changing P/E”—contribute to the literature supporting the persistent overvaluation of the earnings prospects for growth stocks.
Their working hypothesis was that the differing experiences of glamour and value investors can be explained by the well-documented behavior of anchoring.
Anchoring is a form of cognitive bias in which people place an inordinate amount of importance on certain values or attributes, which then act as a reference point, and the influence of subsequent data is weighted to support their initial assessment. For example, some investors will tend to hang on to a losing investment because they’re waiting for it to break even, anchoring their investment’s present value to the value it once had.
Anchoring is such a powerful force that, even in experiments when subjects could plainly see the anchor and that it could not possibly be any sort of guide to an answer, the bias continued to play a role.
For example, in a famous experiment, Daniel Kahneman and Amos Tversky asked subjects to spin a roulette wheel rigged to stop at 10 or 65, and then asked them to estimate the percentage of African nations in the United Nations. Subjects who saw a result of 10 guessed 25% while those shown 65 guessed 45%.
Anchoring On The P/E Ratio
Anderson and Zastawniak hypothesized that investors may anchor on the price-to-earnings (P/E) ratio of a stock when they initially invest in it.
They write: “Given an observed high P/E of 25 [investors] may think (consciously or not), ‘Thousands of investors, some of whom are better informed than I am, already are paying $25 for each $1 of current earnings. This must be a valuable, high growth company to justify that.’”
The authors then posit that such investors “fail to adjust their future expectations sufficiently according to mean reversion.” Thus, having now bought the stock, investors “expect the P/E to change slowly, if at all. As time goes on, the P/E decile changes, and different prospects for returns attach to each decile. If there is a differential drift in the P/E and hence returns between value and glamour stocks that are not expected by investors, this could account for why glamour investors end up disappointed.”
Anderson and Zastawniak’s study covered the period 1983 through 2010. When ranking stocks and forming P/E deciles, they divided positive P/E companies into deciles and then added five more deciles to include the firms with losses (34.1% of the company/year data points represent losses), producing a total of 15 “bins.” They then used these 15 bins, as the loss-producing companies represented about one-third of the total.
They paired each year’s decile number with the decile to which the company moved in the following year. If no earnings were recorded the following year, decile “00” was coded, as the company went into administration, was taken over or otherwise ceased to be quoted. There are thus 15 bins in year 1 and 16 bins in year two, resulting in 240 (or 15×16) possible transitions from one year to the next. Finally, they calculated the equally weighted return from each of these 240 possible transitions.
Study Results
Following is a summary of Anderson and Zastawniak’s findings:
Conclusions
When considered together, the authors write, the findings support their thesis that glamour investors anchor on the high P/E value for growth shares while ignoring the high likelihood that the P/E ratio will change in the future.
Later this week, we’ll take a closer look at a possible explanation Anderson and Zastawniak offer to account for investors’ preference for growth stocks, as well as some other evidence in the academic literature that supports their findings.
This commentary originally appeared March 28 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
Earlier this week, we examined a recent study contributing to the literature that supports a behavioral-based argument for the value premium, in particular that investors persistently overvalue the earnings prospects of growth (“glamour”) stocks.
The study—“Glamour, Value and Anchoring on the Changing P/E”—posits that the differing experiences of glamour and value investors could be explained by the well-documented behavioral bias of anchoring, specifically that investors may anchor on the price-to-earnings (P/E) ratio of a stock when they initially invest in it.
As we discussed, anchoring is a form of cognitive bias in which people place an inordinate amount of importance on certain values or attributes, which go on to act as a reference point, and the influence of subsequent data is weighted to support their initial assessment.
The authors of the study, Keith Anderson and Tomasz Zastawniak, concluded that, taken together, their findings support the thesis that “glamour investors anchor on the high P/E value for glamour shares, while ignoring the high likelihood of future changes to the P/E ratio.”
Explaining The Appeal Of Glamour
Today we will look at a possible explanation that Anderson and Zastawniak offer to account for an investor preference for growth stocks, as well as some other evidence in the academic literature that supports their findings.
Investors appear to ignore the evidence showing that value stocks provide higher returns than growth stocks. Anderson and Zastawniak provide a possible explanation for investors’ preference for growth stocks: They will anchor on the current P/E of glamour stocks instead of considering the high likelihood that the P/Es of value and growth stocks exhibit a strong tendency toward mean reversion.
Anderson and Zastawniak concluded that investors tend to consider the current P/E of a potential investee firm to be more permanent than it actually is. In an uncertain world, many investors anchor on the current P/E. The result is that, “far from the 37.25% returns they expect to get through their share remaining a glamour share next year, they end up with average returns of only 10.91% and are beaten in their endeavours by value investors.”
Supporting Evidence
There’s strong academic research supporting Anderson and Zastawniak’s findings. For example, in a February 1999 study, “Forecasting Profitability and Earnings,” professors Eugene Fama and Kenneth French tested whether the theory of profitability reverting to the mean stood up to the historical data. They examined the profits from an average of 2,304 firms per year for the period 1964 through 1995. Their conclusions:
Fama and French offered a possible behavioral-oriented explanation for the finding that abnormally low earnings revert faster than abnormally high earnings. They hypothesized that when reporting bad news, companies often become very conservative and try to get all the bad news out of the way at one time (possibly blaming previous management). On the other hand, they tend to spread out good news over time.
If, in fact, reversion to the mean occurs faster than the market is anticipating, this may help explain why growth stocks underperform value stocks. The market may simply be overestimating the amount of time that growth firms would generate abnormal profits. Ultimately, earnings expectations are not met, and this fact gets reflected in lower equity returns.
The reverse is true of value firms. The market appears to overestimate the time it takes for abnormally low profits to revert to the mean. Ultimately, earnings expectations are exceeded, and this is reflected in higher returns.
The Bottom Line
It’s likely that Anderson and Zastawniak’s findings won’t settle the debate about whether the value premium is risk- or behavioral-based (if the latter is the case, the value premium is a free lunch). Keep in mind that the answer to the question doesn’t have to be black or white. Perhaps the value premium, while not being a free lunch (there’s plenty of evidence supporting a risk-based explanation) is at least a free stop at the dessert tray.
The bottom line is that value stocks historically have outperformed growth stocks, and if you think the explanation is risk-based, then you should expect this outperformance to continue. If you think the explanation is behavioral-based, then—unless you expect investor behavior to change—you should expect value stocks to outperform as well.
Also remember that the outperformance of value stocks has been in the academic literature for many decades, and legendary investor Benjamin Graham was advocating the purchase of value stocks 80 years ago.
This commentary originally appeared March 30 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE