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.
Following is a summary of the authors’ findings:
- The investment styles of identical twins (who share 100 percent of their genes) are significantly more correlated when compared with fraternal twins (who share only 50 percent of their genes). However, correlations among identical twins are significantly below 1. Even genetically identical investors demonstrate significant differences with respect to their investment styles. This evidence emphasizes the importance of analyzing how experiences and events during an individual’s life can affect investment style.
- An investor’s style has a biological basis, with a preference for value versus growth stocks partially ingrained already from birth. This biological basis explains between 26 and 40 percent of the difference in investment styles, with the data being statistically significant at the 5 percent level. The common economic component, on the other hand, explains very little of the differences in investment styles (between 0 percent and 11 percent). The remaining variation in investment style is explained by individual-specific experiences and events.
- Experiencing an adverse and significant macroeconomic event can have long-term and persistent effects on an individual’s behavior much later in life. Individuals who have experienced relatively low stock market returns in their lives subsequently do not participate in the stock market, and they take significantly less financial risk if they do participate.
- Investors with adverse macroeconomic experiences have stronger preferences for value investing later in life. In other words, the effects of these experiences are long lasting. Those who entered the labor market in a severe recession (for instance, during World War I, the Great Depression or World War II) maintain portfolios with average price-to-earnings (P/E) ratios that are 3.2 lower (21 percent at the median) compared with those of other investors. This effect is about three times larger for investors who experienced the most severe recessions.
- Investors entering the labor market for the first time during an economic recession are also more value-oriented later on in life. The effect that economic conditions have on investors when they are 18 to 25 years old (the time they are most likely to first enter the labor market) is much stronger than the effect that a similar economic experience has on investors somewhat earlier (10 to 17 years old) and somewhat later (26 to 33 years old) in life. The differences are statistically significant.
- Investors with more salient experiences of difficult economic conditions (exemplified by growing up in a lower-status socioeconomic environment characterized by the absence of financial resources) develop a more value-oriented investment style.
- Investors who have experienced stronger economic growth tend to adopt relatively more growth-oriented investment styles. Given a 1 percent per year higher average GDP growth experience, the average P/E ratio of the stock portfolio held by these investors is 1.4 higher (9 percent when compared with the median). The data is statistically significant at the 5 percent level.
- Portfolios of older (younger) investors are significantly more oriented toward value (growth). The average P/E ratio of the stock portfolio held by a 65-year-old investor is 6.0 lower (39 percent at the median) compared with a 25-year-old.
- Besides age, only disposable income has a significant effect on the portfolio’s value versus growth orientation. Investors with more human capital (in the form of higher levels of education and greater amounts of labor income) prefer growth stocks, as do investors whose labor income co-varies more positively with economic growth. That is, investors whose labor income is reduced in bad states of the world prefer growth over value stocks, a behavior that’s consistent with models in which the value premium represents compensation for distress risk.
- Men, who are often more risk-seeking than women, have an insignificant value tilt in their portfolios.
- Investors who select high-volatility portfolios also tilt their portfolio toward growth stocks.
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.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.