Monday, March 9, 2015

Value Investing Works---So Why Don't Individual Investors Do It?

I once heard a quote that the stock market is the only store where when things go on sale people leave.  We are all value investors at heart, just look at stores on Black Friday.  There has also been tons of academic research that value investing beats the market handily over time and that investors who put money into a market when it is undervalued do well, while investors who put money into an overalued market do poorly.

So if it is that easy why doesn't everyone do this?  Two reasons---the media effect, and the watch your neighbor get rich effect.

Media Effect----Value investors often have to be patient, it can take time for investors to recognize value so it is typically a longer term approach.  Value will also often underperform during times of speculative excess.   Therefore, it is very hard to be a value investor when you constantly turn on the TV or open the paper and hear about new highs.

Watch Your Neighbor Get Rich Effect---Many people think losing money is the most difficult thing to stand in the market, its not.  The most difficult thing to do is watch somebody else make money while you are not.  There is always some hot stock or hot sector somewhere and we all know somebody who is making money investing in it.  The longer that goes on the more tempted you become to buy it, once you finally capitulate it is frequently right at the top.

These two effects turn investing into a short term proposal, where the most important thing is how much you are making every day, week, or month.  The problem with that thinking is that those gains are just on paper and you typically give them all back, and then some, when the market goes down.  It is extremely hard to do but you need to look at investing as a longer term proposal.

You can make value investing more palatable and profitable by combining it with momentum and tactical asset allocation.  People who buy when there is "blood in the streets" will almost always make more money over time.  However, psychologically this is the hardest thing to do and often times you will be catching a falling knife.  Using momentum with value can avoid value traps where you buy something after it has gone down a lot and it keeps falling.  Value strategies are also not immune to drawdowns during bear markets.  Adding a tactical overlay can help cut maximum drawdowns down to a reasonable level.

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