These decision biases wouldn't be much of a problem if we could easily recognize and compensate for them. Unfortunately, the second fundamental assumption of the behavioral economics camp shows why this is much easier said than done: most of us are overconfident in the accuracy of the estimates and decisions we make. A number of writers have theorized that both of these traits -- cognitive resource conservation and overconfidence -- evolved as useful adaptations to the environment faced by primitive human beings (see, for example, "One the Evolution of Overconfidence and Entrepreneurs" by Bernardo and Welch, or "A Model of Overconfidence" by Bruce Weinberg). As such, they are "hard-wired" into our systems, and very difficult for us to change.
The behavioral theories behind the value premium are thoroughly covered in four papers: "A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets" by Hong and Stein; "A Model of Investor Sentiment" by Barberis, Shleifer, and Vishny; "Covariance Risk, Mispricing, and the Cross Section of Equity Returns" by Daniel, Hirshliefer, and Subrahamanyam; and "Prospect Theory and Asset Prices" by Barberis, Huang, and Santos. Distilled into a few sentences, the essence of the behavioral camp's argument is that investors underreact to new information which contradicts the views that they hold about a stock. For example, the price of a stock that people view as having good growth prospects will respond only slowly to the arrival of negative news that undermines this view. As a result, it will tend to overshoot its fundamental value. Similarly, the price of a stock that is viewed as having poor prospects tends to respond slowly to the receipt of good news. As a result, its market price may be well below its fundamental value. This tendency to underreact generates both momentum profits (in the first case) and value profits (in the second case). It also explains why the historical risk/return ratio on value stocks is superior to that on growth stocks. So the behavioral camp's views sound plausible in theory. But is there additional evidence?
In their paper "New Paradigm or Same Old Hype in Equity Investing", Chan, Karceski, and Lakonishok find that behavioral factors were largely responsible for the high returns on large cap growth stocks in the late 1990s. In "Book to Market Equity, Distress Ris, and Stock Returns", Griffin and Lemon demonstrate that distress risk alone can't fully explain the difference in returns between high and low book/market firms. They conclude that evidence of mispricing exists. Similarly, in "Do Stock Prices Deviate From Their Fundamental Values?", Anderson, Darrat, and Zhong find evidence of irrational investor behavior. Finally, in "The Price Impact and Survival of Irrational Traders", Kogan, Ross, Wang, and Westerfield show that it is not always possible for rational investors to exploit the mistakes of irrational investors (that is, to arbitrage away their profits, and drive them from the market). They also show how the presence of just a few irrational traders can have a large impact on stock prices.
At this point, the logic behind the behavioral arguments is almost compelling. But not quite. An important caution is raised by Mark Rubinstein in his paper "Rational Markets: Yes or No? The Affirmative Case". He begins by pointing out that "the existence of temporary predictable patterns in security returns isn't precluded in rational markets… given that saving is just delayed consumption, and given that the growth in aggregate consumption over time isn't random, we should not expect market returns to be random either…Moreover, other factors, such as short sales constraints, liquidity fluctuations, uncertainty about other investors' beliefs, and uncertainty about true values of key valuation model variables can also cause periods of predictability in market returns."
What is precluded in reasonably rational, reasonably efficient markets is the ability to profitably exploit these temporary return predictabilities. "Profitable trading strategies are by their nature self-destructive: they have a tendency to move prices against themselves as they are exploited. Eventually, they are discovered and eliminated from overuse by other investors." As proof of this proposition, he notes "the continuing underperformance over time of actively managed funds versus index funds." Clearly, active fund managers have very strong economic incentives to develop investment strategies based on the exploitation of return predictabilities . That they haven't demonstrated a consistent ability to do so is further evidence that markets are basically efficient, and that anomalies like the value premium are difficult to profitably exploit.
On balance, it appears to us that both camps' arguments make sense, and neither is wholly right or wrong about the value premium. Based on the evidence we have seen, we conclude that while most of the value premium is probably explained by higher risk, the superior risk/return tradeoff versus growth stocks probably reflects the existence of behavioral factors and market inefficiencies. We further suspect that the wide fluctuations in the annual size of the value premium reflect constant change in the relative weights applied to rational and behavioral factors. Given this, we would only recommend tilting toward broad based value indexes if a person is a long term investor (as the probability of actually realizing the value premium is high only in the long term) with a strong stomach (as the anxiety caused by watching growth indexes outperform value indexes over some periods may be too much for some people to take). If you don't meet these requirements, we believe that the best course of action is to invest in broad based equity indexes, and avoid taking "value" (or "growth"!) tilts.