A large portion of articles produced by financial publications are devoted to the philosophy of value investing. Focusing on company fundamentals, buying at prices that are below intrinsic value and being greedy when others are fearful are all elements that are intuitive and should be easily comprehensible to most people. The track records of investors like Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) provide empirical evidence of the effectiveness of these strategies. So this raises the question: if value investing is so effective, why are there so few value investors? In his introductory essay to the sixth edition of Benjamin Graham and David Dodd’s "Security Analysis," investor Glenn Greenberg (Trades, Portfolio) shared three reasons for this phenomenon.
Aversion to boredom
“Careful research takes time and seldom results in a clear case for buying a large position. It is tedious to review company after company, only to find that most are neither really special nor greatly undervalued. It is equally tedious to hold shares in a good company for an extended period. Even if the investment does well, most of the time it feels like the stock is treading water or even going down. Part of the problem is that the value of the business is quoted 6 1â„2 hours a day, 5 days a week, 52 weeks a year, and market liquidity tempts us to trade from one stock to another.”
There are several components to this boredom factor. The first is it is simply too difficult and time-consuming for most people to conduct detailed research into companies that are typically in unglamorous sectors (manufacturing, primary materials, logistics, etc.). The second component is a feature of modern technology - by lowering the barrier for entry into the stock market and making it as easy as possible to trade, the temptation to switch in and out of positions has grown. In this sense, the gradual decline in transaction costs has arguably created new problems for investors.
Emotions overwhelming reason
“The second challenge to rational investing is to maintain one’s logical convictions in the face of excess gloom or euphoria as reflected in stock prices. I doubt many owners of private companies are preoccupied with the value of their business on a short-term basis—how different from the public markets, where a rising stock price makes us feel smart and a falling one makes us feel dumb. In my office, when one of our businesses is floundering and the stock is getting pounded, my partners and I start to doubt the reasoned basis upon which we made the investment. Our self-doubts and fears of failure cause us to glimpse catastrophe where once we envisioned opportunity."
Even the most mechanical and emotionless investors are still ultimately human. It is one thing to know intellectually that price does not always equal value, and a very different thing to sit stoically and watch one’s portfolio decline. Given how loss-averse most reasonable people are, it is no wonder that only a small percentage of the population possesses the mental fortitude required for successful value investing. To quote Graham and Dodd: “Obviously it requires strength of character in order to think and act in opposite fashion from the crowd and also patience to wait for opportunities that may be spaced years apart.”
Greed
“The third factor, greed, has always distorted investors’ behavior, but it is especially present in markets today given the proliferation of hedge funds. Investors in these funds keep jumping from fund to fund, trying to latch on to the latest hot manager. The high fees encourage these managers to pursue “get-rich-quick” trading strategies. The more money they make, the more money they attract, and investors have been sold on the promise of unsustainably high returns. A cycle ensues as hedge fund investors quickly move their money from fund to fund, and hedge fund managers try to swing for the fences every month.”
Although not all participants in the stock market are attracted to (or are able to invest in) hedge funds, the basic principle in this sentiment is applicable across a wider range of asset classes. Seeing the runaway gains investors in high-flying growth stocks are able to achieve in a hot bull market can make anyone jealous. In such a context, it is unsurprising that many people forget the Grahamite precepts of buying below value and the margin of safety.
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