Swedroe: ‘Value’ Fueled By Behavior Bias

Swedroe: ‘Value’ Fueled By Behavior Bias

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

Reviewed by: Larry Swedroe
Edited by: Larry Swedroe

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 www.stern.nyu.edu/~jwurgler. 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.


Surprisingly, Shefrin found the anomaly to hold even with the portfolio managers at the hedge funds he studied. He did find that the judgments of the fund’s director of research and chief investment officer (CIO) were in line with the traditional finance view. However, his analysis also showed that less than 15 percent of the portfolio managers and analysts reporting to the CIO formed like-minded judgments.

Instead, most expected higher returns from larger-cap stocks than from smaller-cap stocks; expected higher returns from growth stocks than from value stocks—and, overall, judged the relationship between risk and return to be negative.

Shefrin noted that before seeing the analysis of their judgments, virtually all participants indicated that in principle, they believed risk and return are positively correlated. Most were astonished to discover that, in practice, they judge the relationship to be negative.

Many who favored investing strategies focused on smaller companies and value stocks were astonished to discover that they expected higher returns from large-cap growth stocks rather than from small-cap value stocks. Given this finding, it’s not surprising that most individual investors exhibit the same behavior.

Shefrin concluded: “I suggest that taken together, four elements combine to make the case that prices are not fully rational. Instead, they reflect behavioral biases. First, Baker and Wurgler document return predictability based on sentiment. Second, the relationship between investors’ judgments of expected return and Baker-Wurgler sentiment is positive and statistically significant. Third, investors’ judgments of risk display sentiment-conditioning patterns that are consistent with Baker and Wurgler’s cross-sectional findings for realized returns. Fourth, the judgments about risk and expected return in my data feature biases that are strong and consistent over the fifteen years of my sample.”

Shefrin also concluded that “judgments of risk are major drivers of realized returns whose influence is mediated by judgments of expected returns. As a general matter, irrational investors expecting higher returns from safer stocks bid down the prices of riskier stocks by amounts unwarranted by fundamentals. As a result, their actions lead these stocks to generate positive abnormal future returns. I suggest that this can explain why low-beta stocks, value stocks, and the stocks of small firms are associated with positive abnormal returns.”

If Shefrin is correct, if the value and size premia aren’t a free lunch, at least they’re a free stop at the dessert tray.

Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.


Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.