Gut Reaction

William Ehart

BEHAVIORAL ECONOMISTS long ago discovered that the pain we feel from a $1,000 loss is about twice as great as the joy we feel from a $1,000 gain. Daniel Kahneman and Amos Tversky documented the phenomenon and coined the term “loss aversion” in 1979. That was just a few years before I began investing.

Since then, I’ve made a discovery about my own psychology: I’d rather underperform in out-of-favor stocks than risk losses in glamorous ones—because my gut tells me that the more something is celebrated, the harder it’ll fall.

I feel like I was a contrarian even before 1992, when Eugene Fama and Kenneth French advanced their three-factor model. They showed that neglected value stocks, especially those of smaller companies, were the best performers going back to 1926. Their model purports to explain why that happened and why this outperformance should continue.

Maybe if I’d been Mr. Popular in high school, I’d feel more at home in a crowd, more comfortable buying stocks others are bragging about. If my Little League team hadn’t sucked, I might not gravitate so much to the underdog. If I weren’t so egotistical, I might not feel this overwhelming desire to win by betting against everyone else.

In other words, I need to admit that my preference for unloved stocks might be driven more by my gut than my brain. It’s probably as much a hunch as it is a conclusion based on historical research. If Fama and French had said in the 1990s to buy popular shares like Microsoft, Walmart and Home Depot, I might have ignored them.

Today, the Fama-French model has more doubters than ever. There’s serious debate about whether the valuation metric they used—price-to-book value—is still useful. Book value doesn’t capture intangible factors that can add to a company’s worth, such as the intellectual property the corporation owns or the value of the brainpower that rides up a company’s elevators every morning.

Indeed, outrageously high price-to-book values didn’t slow the advance of today’s dominant tech stocks over the past 14 years. From late May 2007 through early September 2020, the Vanguard Growth Index ETF soared 354%. The Vanguard Small-Cap Value ETF? Just 99%. In the year since, the tables have turned modestly.

We don’t and can’t know which areas of the market will outperform. Even if the most perspicacious investors could theoretically figure it out, we all have strong behavioral biases that cloud our crystal ball, no matter how much information we have. All of this is just further evidence, in my mind, that the vast majority of our stock allocation should be in market capitalization-weighted index funds. Mine is, though I can’t completely ignore my gut, which is why I still dabble in small-cap value at home and abroad.

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Roboticus Aquarius
Roboticus Aquarius
1 year ago

I have a hard time with FF, even if I accept some of their findings.

Value and Growth tend each dominate for several years then swing the other way: to me they seem ripe for trend followers. Between the two I’m agnostic. Also, SCV outperformance is predicated on a very short streak in a very limited time period, although I have to note that many value proponents claim it is a ‘robust’ factor that is found in many countries and time periods. Lastly, company structure is changing over time, which makes me question ‘value’ even more.

I do believe that size played a role in the past (despite it being a ‘weaker’ factor than value), and my portfolio over-weights small and mid caps… and even if this ‘factor’ is not real or has changed, I suspect that permanent under-performance is not likely. This approach seems safer than value to me, making it easier for me to ‘stay the course’.

Mostly, though, I think holding something close to ‘the market’ is hard to beat.

Last edited 1 year ago by Roboticus Aquarius

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