The market as a whole is impacted by this. In certain phases, the market will focus very strongly on some risks, only to leave out other risks that aren’t the current focus or that go against whatever is in trend. At the moment, for example, it seems as though business risk with regards to disruptors seems highly prioritized by the market, whereas valuation risk from inflated values relative to their fundamentals is seemingly ignored.
Let’s say for example that you want to outperform but only have two companies to invest in. One is Amazon and the other is Macy’s. Which one of these businesses appear to be more risky, and which stock should empirically then yield the highest return? The company with the highest growth and high margins, or the company with a higher degree of volatility, cyclicality and business risk? In theory, Macy’s investors should be compensated for the additional risk they take on. These risks – business risk, economic cyclicality, and general uncertainty – can be seen in many of today’s value stocks. These “real” risks lead to agency risk and behavioral flaws, the factors identified by the second camp. The more uncertainty an investor faces, the more pressure builds up. For long term investors, the short term should not have such a strong impact. That is where the psychological phenomenon “myopic loss aversion” comes into play. It describes an extreme focus on the short term, leading to overreactions to recent losses to the demise of long term performance. Bernatzi and Thaler show that investors who regularly analyze their portfolios and the fluctuation of values implicitly accept lower returns than investors who evaluate outcomes less often. The reason is that the probability of observing a loss is much higher when investors look at their portfolio in shorter intervals.
This is described well by Joel Greenblatt in his recent discussion with Richard Pzena: “The best performing mutual fund for the decade of the 2000’s actually earned over 18% per year over a decade where the popular market averages were essentially flat. However, because of the capital movements of investors who bailed out during periods after the fund had underperformed for a while, the average investor (weighted by dollars invested) actually turned that 18% annual gain into an 11% loss per year during the same 10 year period."8
As investors feel their losses, investment managers come increasingly under pressure, enhancing agency risk. Market and investor pressure causes more emotional behavior, clouds judgment and causes mistakes to occur – ultimately leading to mispricing. Numerous studies and books have been published on this subject, with examples of behavioral risks including but are not limited to the following:
- Adjustment and anchoring bias
- Availability bias
- Base-rate neglect
- Confirmation bias
- Fear of missing out (FOMO)
- Halo effect
- Herding & peer pressure
- Mean reversion underestimation / confusion
- Myopic loss aversion
- Outcome bias
- Representativeness bias
- Social proof
- Sunk cost
- Survivorship bias
Value derives its extraordinary long term returns from a combination of uncertainty arising from different types of risk, emotions and agency risk. All of these factors are intertwined in our view and we don’t believe one has to be strictly in one camp of the value debate. The markets are dynamic and things change, however, one thing will not change. One cannot expect to have value outperform for him/her without the presence of discomfort. Free lunches are not given in the market, and the real source of value can be found in the discomfort others feel when faced with uncertainty, but in reality, everything in investing faces uncertainty. Less visibility and a wider spread of outcomes lead to more uncertainty. This, in turn, leads to more perceived risk, which enhances agency risk and increases emotional processes. This also works the other way around: the less risk is perceived, the more willing an investor becomes to pay a high multiple and to take on more valuation risk.