Index Investor Corner

Swedroe: ‘Value’ Fueled By Behavior Bias

May 12, 2014

The risk and value premia are affected by both risk and subjective investor perception of risk.

The financial equivalent of the Miller Lite, “tastes great, less filling,” debate is between traditional finance (which uses risk theories to explain asset pricing), and the newer behavioral finance field (which uses human behavior to provide the explanations).

Unfortunately, there’s no consensus about which side of the debate is correct. My own view is that both have much to contribute to the discussion. In other words, the story isn’t all one-sided—it’s not black or white. Instead, it’s some shade of gray.

Hersh Shefrin, one of the leaders in the field of behavioral finance, contributes to the literature with his May 2014 paper “Investors’ Judgments, Asset Pricing Factors, and Sentiment.” In his research, Shefrin uses a metric called “investment sentiment”—a measure of investor optimism developed by Malcolm Baker and Jeffrey Wurgler.

The investor sentiment index is based on a number of measures, including trading volume as measured by New York Stock Exchange turnover; the dividend premium (the difference between the average market-to-book ratio of dividend payers and nonpayers); the closed-end fund discount; the number of and first-day returns on IPOs; and the equity share in new issues.

Data on the sentiment index is available at Using data covering the period 1999-2014, Shefrin came to the following conclusions:

  • Investors’ collective judgments about risk and expected return display some features of rational pricing. However, they also exhibit some behavioral features.
  • There’s consistent evidence that investors’ judgments about risk are negatively correlated with market capitalization and positively correlated with the value metric of book-to-market.
  • Despite judging large companies to be safer than small companies, and growth companies to be safer than value companies, investors expect large companies to have higher returns than small companies and growth companies to have higher returns than value companies. In other words, investors act as if they believe that risk and expected return are negatively, not positively, related.
  • Investors’ collective judgments about the cross section of expected returns are consistently at odds with the cross section of realized returns and rational economic thought, which holds that risk and expected return are positively related. Only 10 percent of investors make judgments about risk and return that are in line with the traditional finance view. The anomaly is explained by persistent behavioral biases that investors exhibit.



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