Are you a value investor or a growth investor? Could your preference be influenced by a biological predisposition partially ingrained from birth? Is it possible that your choice of investment could be explained by your personal experiences, both early on and later in life?
The field of behavioral finance advances psychology-based theories to explain investor behavior, behavior that can lead to anomalies that can’t be explained by an efficient market made up of investors who always act rationally.
Henrik Cronqvist, Stephan Siegel and Frank Yu—authors of the study “Value Versus Growth Investing: Why Do Different Investors Have Different Styles?”, which appears in the August 2015 issue of the Journal of Financial Economics—contribute a new perspective to the long-standing debate over the two different styles of investing: value and growth.
Today there are more than 2,000 value funds and about 3,200 growth funds that cater to investors with a preference for this pair of investment styles. For more than two decades, Morningstar has provided investors with tools to help them choose a fund with their style of choice. And of course, there are hundreds of books promoting these two very different styles.
The question Cronqvist, Siegel and Yu sought to answer is: Why are some investors relatively more value-oriented, while others are more growth-oriented?
Biology & Environment
Since human beings are all shaped at least to some degree by both genetics and our experiences, it seems reasonable to expect that our views on investing would also be shaped by these two factors.
For example, research on human behavior has found that an individual’s core beliefs and preferences seem to crystallize during a period of greater neurological plasticity in early adulthood, the so-called impressionable years, and remain largely unchanged thereafter.
Thus, it should come as no surprise that research has found experiencing an economic recession during the impressionable years (18 to 25 years old) significantly affects redistribution and political preferences much later in life.
Cronqvist, Siegel and Yu’s study offers evidence supporting this concept when it comes to our investment choices. They show that differences in investment styles across individuals stem from two nonmutually exclusive sources: a biological predisposition that translates into a preference for value or growth stocks; and environmental factors that determine an individual’s portfolio tilt with respect to value and growth.
To study the extent to which variation in investment styles across a large sample of individual investors reflects innate differences, the authors employed data on identical and fraternal twins.
They constructed their dataset, which included 10,490 identical twins and 24,486 fraternal twins who invest in the stock market, by matching a large number of twins from the Swedish Twin Registry, the world’s largest twin registry, with data from individual tax filings and other databases. The study covered the period 1999 through 2007.
Research Results
Following is a summary of the authors’ findings:
Free Dessert?
Of particular interest is the twin finding that investors’ biases—in particular a possible preference for lottery-type stocks—make them favor growth over value stocks and that hedging of labor capital demand leads to an investor preference for growth stocks.
This helps us understand that the value premium likely reflects both risk-based compensation and mispricings due to speculative retail investors, providing support for the idea that, while the value premium is not a free lunch, it just might be a free stop at the dessert tray.
The authors concluded: “Overall, we find support for the hypothesis that life experiences affect an individual’s investment style. By controlling for education, income, and net worth, we can rule out that these effects operate merely through an investor’s economic circumstances. Instead, our evidence is consistent with experiences early in life affecting investors’ preferences and beliefs.”
These findings can help investors by providing them with possible insights into their investment decisions, decisions that may not be optimal due to biases. They can also help financial advisors achieve a better understanding of the preferences/choices of their clients/prospects, as well as help advisors to explain to an investor why a decision may have been influenced by genetics and personal experiences rather than being based on academic evidence and rational decision-making.
This commentary originally appeared November 2 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.
© 2015, The BAM ALLIANCE
Almost 10 years ago, I knew a guy on a financial rocket ship. He had a great house, a successful business and a solid income.
But then things changed. With the benefit of hindsight, it was clear he bought a little too much house and spent a little too much money. At the beginning, he was rewarded for buying the house. Its value went up a lot in a short time. For context, imagine Florida, Arizona or Las Vegas in 2006-7. Houses were selling even before hitting the official market and for way more than the asking price.
Things continued to go well for this guy, and he decided to borrow money against the equity in his home to start a new business. But not long after, the rocket ship ran out of fuel.
The value of his home dropped. In fact, the house eventually was worth less than what he paid for it. Then, his income dropped significantly because his business was tied closely to the local economy.
Again, with the benefit of hindsight, this story looks like a series of obvious mistakes. And to his credit, this guy took full responsibility for every one of those decisions. Along the way, he dealt with mental and physical stress while trying to juggle the web of consequences arising from this experience.
I imagine you can relate personally to this story or know someone who can. Given our history of booms and busts over the last 15 years, you’ve probably watched some version of this story play out more than once.
Now fast-forward a couple of years. This guy had a bunch of stuff go well in his life. He now has superpositive net worth. His relationships are better than ever. He has taken steps to avoid repeating earlier mistakes.
I share this story because I am that guy. I have asked myself over and over, “What did I do wrong to deserve the bad experience?” And then more recently, “What did I do right to deserve the good experience?”
Notice how loaded the language is, with the emphasis on whether and when I was deserving.
Over a series of conversations with a friend, I talked through my story and realized I could only identify the mistakes I made with the benefit of hindsight. As is often the case, it is very easy to look backward and make up stories about why certain things happened and then take either the blame or the credit for them. The reality of life is often a bit more nuanced. As I carefully reflect on the good and the bad experiences, I have come to the conclusion that, in both cases, I was simply doing the best I could with the knowledge and experience I had at the time.
But when we look back at our stories, we need to be careful. Because, as I told my friend, “I can’t define exactly what I did to deserve the bad stuff or to deserve the good stuff.”
Based on my past experiences, I reasoned with my friend, “If you fast-forward five years, I could end up homeless or own a private jet, or anything in between.” This friend, who happens to be a life coach, replied, “Yeah, and if you can get yourself to accept that, you’ll finally be free.”
It took me awhile to understand what he meant. But I realized he was talking about the freedom we feel when we let go of the idea that we “deserve” any specific outcome.
We’re certainly not free of personal responsibility. But consider the people who say they believe they can control their future. They tell themselves the story that if they just plan carefully enough, they can achieve certainty about what will happen.
For years, many of us have believed this myth. In reality, life is irreducibly uncertain. That doesn’t make us more or less successful or more or less happy. The true joy in life, the real peace, comes when we let go of the idea that we deserve a predetermined happy ending.
Of course, we’re going to have a goal on the horizon, and we’ll head toward it. But we may wake up tomorrow and say, “I’m not sure that’s the best direction to go anymore.” We then need to ask ourselves if things have changed, or if our goal just feels too hard. Do we need to push through a tough spot or chart a different path?
Right now, I’m working really hard on both having goals and accepting the reality of uncertainty. In fact, I embrace the uncertainty and say to myself, “Given that goal, and given the uncertainty, what’s to be done next?”
I repeat this process over and over. Every once in a while, I stick my head up and say, “I still want to head to that goal. Yes, I’m uncertain I’ll get there, but for now, I think that’s where I want to go.” Then, I put my head back down, figure out what’s to be done next and go do it.
Whatever the goal, we can learn to trust ourselves and deal with the reality of uncertainty. And for me that’s become the definition of true freedom.
This commentary originally appeared October 12 on NYTimes.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.
© 2015, The BAM ALLIANCE
Is it time for stock-pickers to make a comeback? That was the topic of discussion during a recent Trading Nation segment in which CNBC’s Brian Sullivan interviewed Stacey Gilbert of Susquehanna, and Phillip Streible of RJO Futures.
Gilbert and Streible made the case that because the correlations (a measure of the strength of the linear relationship between two variables) between stocks, which had been quite high, cratered in October, these now-lower correlations provide an opportunity for stock-pickers to shine. As evidence, they showed the trend in what is called the Implied Correlations Index. For those interested, you can find a paper on the index here.
Sullivan eventually asked his guests the question: will next year be a good year for stock-pickers?
Excuses, Excuses
As sure as the sun rises in the east, this question is asked every year. And each and every year, active managers come up with yet another excuse for why they previously failed – in addition to an explanation for why the next year will be different. A recent common excuse from active managers has been that the increased correlation between stocks is making it difficult for them to outperform. Just like their other excuses, this one holds as much water as the proverbial sieve. Let’s see why this is the case.
Correlation shows the directional movement of stocks, not the magnitude of their movement. Magnitude is shown by the dispersion of returns: that is, the size of differences in the returns of individual stocks or asset classes. The greater the dispersion becomes, then the greater the opportunity for active management to add value by overweighting the winners and avoiding the losers. Thus, it’s the dispersion of returns we should examine, not the correlations, to see how high the hurdle is for active management.
It’s important to note the correlations of all risky assets, which tend to rise toward 1 during crises. The rise in correlations we experienced during the financial crisis of 2008-2009 is neither unprecedented nor unexpected. That said, in its May 2012 paper Dispersion! Not Correlation! The Vanguard research team showed that while correlations between stocks during that period had increased, the dispersion of returns remained stable.
In each of the five calendar years from 2007 through 2011, which included bull, bear and flat markets, the degree of dispersion was such that at least two-thirds of all stocks either led or trailed the index by more than ten percentage points, ranging from a low of 67% and a high of 79%. Clearly, there was plenty of opportunity for active managers to add value. They just weren’t able do it with any persistence, as the Standard & Poor’s Indices Versus Active (SPIVA) scorecard regularly demonstrates.
Here’s another example from 2014, when high correlations again were used as an excuse by active managers for their failures to deliver alpha. Even though the S&P 500 Index returned 13.7% in 2014, the two tables below clearly demonstrate that active managers had great opportunity to generate alpha.
There were ten stocks in the S&P 500 that returned at least 62.4% last year, and ten stocks that lost at least 35.0%. All active managers had to do was overweight these big winners and underweight or avoid these big losers.
| Ten Best S&P 500 Performers in 2014 | Percent Return (%) | Ten Worst S&P 500 Performers in 2014 | Percent Return (%) |
| Southwest Airlines | 124.6 | Transocean Ltd. | -62.9 |
| Electronic Arts | 104.9 | Noble Corp. | -55.8 |
| Edwards Lifesciences | 93.7 | Denbury Resources | -50.5 |
| Allergan Inc. | 91.4 | Ensco PLC | -47.6 |
| Avago Technologies | 90.2 | Avon | -45.5 |
| Mallinckrodt PLC | 89.5 | Genworth Financial | -45.3 |
| Delta Air Lines | 79.1 | Freeport McMorRan Copper & Gold B | -38.1 |
| Keurig Green Mountain | 75.3 | Range Resources | -36.6 |
| Royal Caribbean Cruises | 73.8 | Diamond Offshore Drilling | -35.5 |
| Kroger Co. | 62.4 | Mattel | -35 |
As the aforementioned Vanguard study shows, this wide dispersion of returns is not at all unusual.
Stock-Pickers Beware
Active managers will come up with all kinds of excuses, but the reasons for their failure to persistently outperform are well known. First, while markets are not perfectly efficient, they are highly efficient. Second, successful active management sows the seeds of its own destruction. It leads to increased cash flows, which in turn increase the hurdles to generating alpha. Third, active managers not only have higher expense ratios, they have higher trading costs and create more tax inefficiency, which again increases the hurdles to generating alpha – what John Bogle called the Costs Matters Hypothesis.
As William Sharpe in his 1991 paper The Arithmetic of Active Management explained: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”
Sharpe also provided this insight: “The market’s performance is itself an average of the performance of all investors. If, on average, mutual funds had beaten the market, then some other group of investors would have ‘lost’ to the market. With the substantial amount of professional management in today’s stock market, it is difficult to think of a likely group of victims.”
The Bottom Line
The bottom line is that whenever you hear a claim about why active managers are likely to outperform, you should remain skeptical and demand to see evidence from peer-reviewed academic journals providing both the data that supports the claim and the logic behind why the theory should hold up in the future. There’s either a risk-based or behavioral-based explanation. And if you don’t get the evidence, run.
This commentary originally appeared November 4 on MutualFunds.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.
© 2015, The BAM ALLIANCE