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Joel Greenblatt’s Solution to Value Investors’ Behavioral Errors

May 14, 2012 | About:
Last week I looked at James Montier’s 2006 paper The Little Note That Beats The Market and his view that investors would struggle to implement the Magic Formula strategy for behavioral reasons, a view borne out by Greenblatt’s own research. This is not a criticism of the strategy, which is tractable and implementable, but an observation on how pernicious our cognitive biases are.

Greenblatt found that a compilation of all the “professionally managed” – read “systematic, automatic (hydromatic)” – accounts earned 84.1 percent over two years against the [b]S&P 500 (up 62.7 percent)[/b]. A compilation of “self-managed” accounts [b](the humans) [/b]over the same period showed a cumulative return of 59.4 percent, losing to the market by 20 percent, and to the machines by almost 25 percent. So the humans took this unmessupable system and messed it up. As predicted by Montier and Greenblatt.

Ugh.

Greenblatt, perhaps dismayed at the fact that he dragged the horses all the way to the water to find they still wouldn’t drink, has a new idea: value-weighted indexing (not to be confused with the academic term for market capitalization-weighting, which is, confusingly, also called value weighting).

I know from speaking to some of you that this is not a particularly popular idea, but I like it. Here’s Greenblatt’s rationale, paraphrased:

  • Most investors, pro’s included, can’t beat the index. Therefore, buying an index fund is better than messing it up yourself or getting an active manager to mess it up for you.
  • If you’re going to buy an index, you might as well buy the best one. An index based on the market capitalization-weighted S&P500 will be handily beaten by an equal-weighted index, which will be handily beaten by a fundamentally weighted index, which is in turn handily beaten by a “value-weighted index,” which is what Greenblatt calls his “Magic Formula-weighted index.”
I like the logic. I also think the data on the last point are persuasive. In chart form, the data on that last point look like this:



The value weighted index knocked out a CAGR of 16.1 percent per year over the last 20 years. Not bad.

Greenblatt explains his rationale in some depth in his latest book The Big Secret. The book has taken some heavy criticism on Amazon – average review is 3.2 out of 5 as of now – most of which I think is unwarranted (for example, “Like many others here, I do not exactly understand the reason for this book’s existence.”).

I’m going to take a close look at the value-weighted index this week.


Rating: 2.5/5 (10 votes)

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