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Value Investing And Behavioral Finance

Behavioural Obstacles To Value Investing

This chapter examines both the Value and Growth investing styles and examines why people prefer one over the other. 


Value is classified into two types: 

  • Value in use 
  • Value in exchange 

Water has a high utility value, whereas gold has a high exchange value. Value Investors should understand the distinctions between the above concepts of value and only invest in companies that offer good value in exchange for a higher return over time.


Recency effect - giving more importance to recent information at the expense of older but relevant information - is one of the behavioural barriers to value investing. Prospect theory states that people place a higher value on loss aversion than profits and tend to sell off profitable investments quickly while keeping (and adding to) loss-making investments in their portfolios. Instant gratification - Lack of patience to stay invested for an extended period. People use PE, PB, and Price / Sales Heuristics to identify value because the process is complex.


The author makes two observations about Growth Investing. For starters, growth is not the same as return. You will not make money if you buy a growth stock at a high price. Two, there is a distinction between good companies and good stocks. It is not always necessary for good companies to be good stocks. There will be a time when the company's performance and potential to provide good investment returns diverge. Another critical point is that investors are hesitant to change their strategies and are sometimes content with sub-optimal returns.


What is Behavioral Finance?

Behavioural finance is a new field that combines behavioural and cognitive psychology with financial decision-making processes. As we know it, traditional economic theory talks about efficient markets and rational decisions to maximize profits. However, this new emerging school of behavioural economists contends that markets are inefficient, particularly in the short run, and that people do not make rational decisions to maximize profits. Humans are prone to various behavioural anomalies that become counter-productive to the wealth-maximization principle, resulting in irrational behaviour.


Key Takeaways


Why do most individual and professional investors refuse to adopt value-investing strategies despite such compelling evidence?

It is abundantly clear that growth investing is risky, even though most people do it.


The author spoke with a fund manager from a large mutual fund about the types of services we could provide. During the decision, the fund manager stated unequivocally that, while he believed in the author's value strategies, he wanted the author to give him ideas on stocks that would rise in the short run.


When the author expressed his inability to do so because it contradicted his investing beliefs and principles, he curtly informed the author that keeping his high-profile and high-paying job was more important to him. Thus he had to rely on momentum strategies rather than being a contrarian and underperforming in the short run. His company will not tolerate poor performance. He lacked the courage to stand up, despite knowing he was doing the wrong thing.


According to Lakonishak, Schleifer, and Vishny, being a contrarian may be too risky for the average person or professional.
If you are wrong along with everyone else, the professional and self-esteem consequences are far less severe than if you are wrong and alone in your choice of action. It's safer to be with the herd because it provides the security of numbers.


Another reason is that people are less likely to change their paths if they are content. Individuals are content with subpar performance as long as it is not painful. Furthermore, people who are unhappy and prone to making changes frequently do so for the wrong reasons and end up being just as disappointed in their new circumstances. Fear of failure and resistance to change may be too powerful to overcome.


Greed and envy appear to be the most common sins for investors caught in the growth trap.


The desire to make a quick buck saps them of all rationality and common sense. Instead, people try to emulate others' success without knowing the risks they took, believing that they, too, will be as successful as them.


No rationality operates in the stock markets because they are inefficient, particularly short.


What works in the stock market is recognising one's emotional and psychological flaws.


This is the initial step. The second step is to comprehend other people's irrational behaviour and profit from their mistakes. The third step is to muster the courage and conviction to deviate from the crowd. That is why value investing is effective. Unfortunately, it's a risky strategy that few people follow. The herd is frequently caught in the growth trap.


Value investing entails knowledge, whereas growth investing entails mystery.

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