The Real Value in Value Investing

When Columbus set off in 1492, a considerable number of people still believed (despite scientific calculations going as far back as the Greeks) that he would sail off the edge of a flat world. As a child hearing this story, I was incredulous that people could have ignored something as obvious as the shape of the Earth. Yet here we are more than 500 years later and despite overwhelming evidence to the contrary, there are still people who believe that the moon landing was staged, that the Holocaust didn’t happen and that Elvis is alive.

People can and do live their entire lives believing almost anything. When indisputable facts run into firmly held beliefs—the beliefs will win almost all the time. This is the world we inhabit.

The world of long-term investing is a fortunate exception: In long-term investing it doesn’t matter what you believe, what everybody else believes, how much money you have, how influential your financial advisor is or what the headlines say—and most definitely it doesn’t matter what the pundits say. All that matters are the facts. The facts are an investor’s compass, his guide for navigating safely through the investment wilderness.

Of course, if investing were that simple, I wouldn’t be sitting at my laptop writing this column. The world throws up one challenge after another: bad information, social pressure, conventional wisdom and the ubiquitous daily noise that distracts all but the clearest-thinking investors from the simple facts staring them in the face.

Undue Influence

Consider the challenges of social conformity. On one hand, without it we couldn’t have a civil society; imagine a world where individuals didn’t follow traffic laws or other laws or any rules of behavior we take for granted. Life as we know it could not exist. Yet social conformity in an investment setting is an impediment to clear thinking and good decision-making.

Solomon Asch’s classic experiment from the 1950s illustrates the dark side of social conformity. A group of students seated in a classroom were asked to participate in a “vision test.” In reality, all but one of the students were confederates of Asch. The students were given a number of different tests, each of which involved two cards, one with a single line and the other with three lines of differing lengths. The “subjects” were asked to identify which line on the second card matched the single line on the first and then to give their answer aloud. All the confederates answered before the actual subject—and all gave the same answer.

Asch wanted to see when the confederates gave obviously incorrect answers, whether the pressure to conform would affect the responses of the actual subjects. What he discovered was that the subjects were influenced to provide incorrect answers nearly a third of the time, and over the course of the experiment 75% of the subjects gave at least one incorrect answer. In control groups, without the pressure to conform, incorrect responses dropped to less than 3%.

There have been many behavioral studies since Asch. All of them demonstrate how difficult it is to stand apart from the crowd, even if you know you’re right. “Misery loves company” means that our poor choices don’t feel so bad when everyone else is making them. However, in investing, doing what all your friends are doing guarantees mediocre long-term results.

Consider the following investment fact: In order for even the best value manager to produce above-average long-term returns, his fund must underperform the overall market, sometimes for extended periods of time. Yet it is next to impossible for most investors to live with underperformance, because the conventional wisdom on Wall Street is that underperforming the market is bad. This assumption and the social pressure that follows from it can lead even sophisticated investors to make terrible decisions.