Why value investing usually outperforms

Overview

Over the past couple of months, analysing monthly returns in the U.S. since January 1926, I’ve demonstrated that

• value stocks greatly outperform “momentum” stocks (for details, see Why value investing crushes momentum speculation, 9 February);
• value also thrashes “growth” (Want to shrink your returns? Buy “growth” stocks! 23 March);
• small caps outperform growth, but value outperforms small caps (Why Intelligent Investors Avoid Small Caps, 13 April).

In those analyses, I also explained why (to put it charitably) momentum, growth and small caps normally fall well short of their advocates’ overconfident expectations – and why (to put it bluntly but truthfully) momentum and growth eventually fail. In this article, I explain why value has usually excelled. I show that value stocks don’t just generally outperform the S&P 500 Index: they also excel at crucial junctures such as extremes when the Index generates above- and below-average results.

Value investors, who in the past have always been a minority, today are likely a small minority and will probably always remain one, usually succeed because (1) their time horizon is long, (2) when necessary they defy the crowd and (3) the majority (speculators) reliably fail.

In particular, speculators systematically overreact: they exuberantly buy high and despondently sell low, and thereby allow value investors to buy low and sell high.

Two Key Junctures When Value Generally Outperforms

In Misbehaving: The Making of Behavioral Economics (WW Norton, 2016), Richard Thaler (recipient in 2017 of the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, which is ubiquitously mislabeled as “the Nobel Prize in Economics”) concluded that value investing works because it represents “a simple regression to the mean.”

His point has two aspects: value outperforms on the upside (that is, when a benchmark such as the S&P 500 Index booms) and on the downside (when it busts).

Mean regression is a statistical phenomenon. If initial measurements of a variable, such stocks’ total returns calculated as CPI-adjusted compound annual growth rates (CAGRs), become extreme (very high or low), then subsequent returns will trend closer (“regress”) to their overall average (mean).

A simple example has profound consequences.

Using data collated by Robert Shiller and Richard French and his colleagues, for each month since July 1926 I calculated (as CAGRs) the rolling five-year (60-month), CPI-adjusted total returns of the S&P 500 and the value, growth, momentum and small cap portfolios (I corrected the latter for its initial mislabeling of micro-caps as small caps; for details, see Why Intelligent Investors Avoid Small Caps, 13 April). For each month, and for each portfolio’s as well as the S&P 500’s CAGRs, I then matched this past five-year CAGR to its CAGR over the subsequent years.

I then sorted these series by the Index’s past five-year CAGRs; separated the data into five equal (by numbers of observations) segments; and for each quintile, computed mean CAGRs for the previous and next five years. Table 1 summarises the results.

Table 1: Mean Five-Year CPI-Adjusted CAGRs, by Quintile of S&P 500’s Previous Five-Year CAGR, Four Portfolios, July 1926-February 2026

It demonstrates that

1. The Index, as well as value, growth and small cap (but not momentum) stocks, regress to their medium-term means: the higher was the CAGR during the preceding five years, the lower it will fall during the next. Equally, the lower was the CAGR during the previous five years falls, the higher it will rise during the next.
2. The value portfolio slightly outperforms the Index on the upswing (the mean CAGRs in Quintile #5 of 20.1% and 19.7% respectively); it also considerably outperforms on the downswing (mean CAGRs in Quintile #1 of -0.8% and -4.2% respectively.
3. On both upside and downside, value almost always outperforms growth and momentum – and usually outperforms small caps.

In short, value stocks haven’t merely outperformed generally (that is, over short-term, medium-term and long-term periods) over the past century; they’ve also excelled during extremes.

On average they’ve outperformed (fallen less than growth stocks, etc.) in Quintile #1 – which contains all bear markets, corrections, crises and market downturns. They’ve also tended to excel (generate higher returns than momentum, etc.) in Quintile #5, which contains subsequent recoveries, upswings and bull markets.

Once Were Investors, Now Are Speculators

Benjamin Graham famously distinguished investors from speculators. In his view, “long-term” is redundant: by definition, investors hold stocks and collect dividends indefinitely; in contrast, speculators chase short-term price fluctuations.

Given that definition, investors have long comprised a shrinking percentage – and are now probably a minority – of actors in financial markets.

According to the World Economic Forum (“Long-term investing: what are the reasons behind its decline?” 17 December 2021), the average holding period of stocks listed on the New York Stock Exchange has collapsed almost 95% – from approximately eight years in the 1950s to just 5.5 months in June 2020.

That’s not just a massive shift towards short-termism: it’s hard evidence that the bulk of market participants – professional, wholesale and retail – are no longer investors; they’re now speculators.

Why has the average holding period plunged? Several explanations have been offered:

• The Rapid Advance of Technology: the availability of real-time market data on mobile devices has encouraged the constant monitoring of price movements – and the rise of online, low-cost and even commission-free trading has made it extremely easy to trade ever more frequently.
• The Rise of High-Frequency and Algorithmic Trading: closely related to the first dot point and according to various estimates, they now constitute 50%-70% of total equity trading volume in the U.S., 40% in Britain and Europe and 25%-30% in Australia. In markets for some American stocks, they can often comprise as much as 90% of trading volume.
• Shortened Corporate Lifespans: the average lifespan of companies which are components of the S&P 500 Index has decreased, and has thereby contributed to higher equity portfolio turnover.

These factors, I suspect, are more symptoms than causes. The ultimate explanation of the collapsing number of investors and the skyrocketing number of speculators is much more profound: it’s an immense, and society-wide, increase of time preferences. Such an increase occurs when people prioritise immediate consumption over future consumption. Its implications are profound. 

A society whose time preference is high and rising doesn’t maintain and expand its existing base of capital: it consumes it. The consumption of capital lowers productivity and standards of living – and thereby bequeaths a less prosperous society to the next generation.

Time Preference Separates Investors from Speculators

Psychological, neurological and economic research generally concludes that a large portion – and likely a majority – of the population is biased towards the present. As a rough rule, in other words, people prioritise today over the future. To a significant extent that’s not just reasonable, it’s essential: nobody can indefinitely delay the consumption of food, drink and shelter. It’s also common sense: given the offer of a reward (say $100), it’s natural to prefer to receive it as soon as possible.

But what about the certainty of $100 today versus the strong likelihood of, say, $200 in five years’ time? Who’ll grab the $100 now – and who’ll choose to defer immediate gratification, bear the risk and await the likelihood of $200?

High time preference – the inability or unwillingness to constrain consumption in the present, and to save and invest in order to consume more in the future – is a common and normal human trait. It derives ultimately from the imperative of survival. Yet it’s paradoxical: in a modern society, the majority’s high time preference impairs – and the low time preference of a minority underpins – the accumulation of long-term wealth.

Saving and investing, which low time preference encourage, enable compounding – which, in turn, is a necessary condition of the creation of wealth and financial security. Low time preference builds and maintains capital, and thus over time improves general prosperity and advances civilisation. It encourages financial and physical health, and thus longevity (see, for example, Daniel Horn, et al., “Time preferences and their life outcome correlates: Evidence from a representative survey,” PLoS One, July 2020). In contrast, excessive consumption, which high time preference encourages, doesn’t just impair and deplete capital and worsen living standards: it shortens lifespans.

Differences of time preference – that is, divergent orientations toward the future – thus explain fundamental differences of mindset.

People whose time preference is high are impulsive, focus upon immediate pleasure and consumption, are less likely to save for the future – and in financial markets speculate rather than to invest. People whose time preference is low, on the other hand, are future-oriented, patient, willing to sacrifice some consumption today so that they or their heirs can consume more in the future. In financial markets, they’re much more likely to invest than to speculate.

Apart from the brain’s hard-wiring, today’s majority’s high time preference results from a combination of factors: 

• Age is a key: because their brains haven’t developed fully, children, adolescents and young adults usually exhibit higher impulsiveness, impatience and inability to delay gratification than older adults.
• Environment can also be important: some events early in life can weaken an individual’s capacity to delay gratification – and others can strengthen it.
• A person’s current economic situation also impacts his time preference: those with lower income or higher economic instability often have higher time preferences because they must prioritise immediate survival over saving and investing.
• The digital economy and easy credit facilitate the demand for instant goods and services, and thus buttress high time preferences.
• Moreover, constant stimulation from “social media” can cultivate – and, among adolescents and young adults, reinforce – a high time-preference mindset, making the delay of gratification even more difficult.

It’s vital to emphasise: the time preference of stock market speculators is generally high (see, for example, Werner De Bondt, “Measuring speculation beyond day trading and bets on lottery-like stocks,” International Review of Financial Analysis, Vol. 96, Part A, November 2024). They strongly prefer $1 of trading profit today rather than the reasonable prospect of $2 of dividends and capital growth over the next few years; hence they prioritise the pursuit of quick gains over the accumulation of long-term wealth. 

They focus intensely – indeed, obsessively – on short-term price fluctuations. Their focus is almost always over intervals of 12 months or less, is usually a few months and is sometimes just days, hours or even minutes. They seek to “time the market” – and have thus been fooled by randomness (see in particular Stop kidding yourself: Nobody can “time the market,” 30 June 2025). In that crucial respect, speculators resemble gamblers: both ignore the odds, seek the excitement of fast profits, tacitly accept high risks in exchange for the prospect of quick returns – and, eventually lose.

Speculators allow the transient and ethereal (sentiment, rumours and immediate news) to distract them, and thereby discount or ignore concrete and long-term fundamentals. 

In contrast, investors focus upon base rates (reliable odds, generalisations and statistical inferences), ignore case rates (anecdotes) and are willing to accept short-term volatility as the price of greater future rewards.

Two Reasons Why Value Investing Works

Firstly, most people’s financial horizon is relatively short. As a result, few can suppress their desire for quick riches; most, therefore, if they enter financial markets, become incorrigible and overconfident speculators. They overweight short-term and mostly ephemeral and tangential information, and discount or ignore long-term fundamentals.

As a result, many and perhaps most people – who are likely speculators – overreact on the upside; they buy when prices are high and rising. Conversely, when upswings become downdraughts, they also overreact; they sell when prices are low and falling.

As a rough rule, therefore, many people often buy high and sell low.

Over the years, DALBAR’s Quantitative Analysis of Investor Behavior analyses have consistently found that, as a result of poor timing and emotional decision-making, the average “investor” is actually a speculator: he underperforms the vehicles in which he invests (which, in turn, typically underperform broad market indexes).

In contrast, the time horizon of a small minority, value investors, is long. They weight long-term fundamentals much more heavily than short-term ephemera; as a result, they buy from pessimists (speculators whose short-term expectations are despondent) and sell to optimists (speculators whose short-term expectations are exuberant). They’re the opposites of speculators, who tend to buy high and sell low.

Value investors’ and speculators’ interactions are symbiotic. The behaviour of the former doesn’t just mirror that of the latter: without the systematic overreactions of the majority (speculators), the minority (value investors) can’t generally outperform.

Secondly, value investing works because the central tenet of mainstream academic finance from the 1960s until the GFC – namely that market participants are robots who never err collectively and systematically – is logically absurd and empirically false.

In particular, if value stocks usually outperform then markets can’t be as “efficient” as eminent academics long insisted. Yet value stocks usually do outperform; hence the crux of mainstream finance was always mistaken.

Logic versus Emotion

The essence of value investing isn’t cognitively difficult to grasp; socially and psychologically, however, it’s very difficult to practice. That’s because it obliges its practitioners to do something that all but a few people are loathe to do: think for themselves, never slavishly follow and occasionally defy the herd.

Among people’s greatest fears is not so much being wrong; it’s being criticised for being wrong. How to avoid this criticism? Remain part of the herd!

Hence most people avoid rigorous and independent thought, and consequent action, when it goes against the flow. They thereby deny Benjamin Graham: “you are neither right nor wrong because the crowd disagrees with you,” he famously observed in The Intelligent Investor. “You are right because your data and reasoning are correct.”

That’s always been – and, I suspect, always will be – the stance of a resolute minority.

In The General Theory of Employment, Interest, and Money (1936), John Maynard Keynes observed that “worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Most people take the socially easy rather than the hard road: they prefer to follow the crowd and fail together rather than take the risk of succeeding alone. Conventional failure protects and even enhances reputation (“never mind; after all, he’s one of us”). Unconventional success, however, invites scrutiny (“who does she think she is?”) – and unconventional failure attracts ridicule and ostracism (“what a dummy – and far worse, he’s NOT a team player!”).

That explains Keynes’ observation of professional investors’ herd mentality. Ninety years ago, they attempted to conform to current “average opinion” rather than identify long-term value. Today, nothing’s changed.

Value investors succeed because logic and evidence – not emotions such as fear and greed – underpin their actions. Their time horizon is long; they therefore suppress the instinct to chase “fast money” – that is, to speculate, which is basically to gamble, which is usually, and eventually almost always, to lose.

In sharp contrast, and as Keynes also noted in The General Theory, “human nature desires quick results. There is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate … Professional investment (as opposed to speculation) is intolerably boring and over-exacting …; whilst he who has (what Keynes dubbed the “gambling instinct”) must pay … the appropriate toll.”

For those who possess the gambling instinct (that is, speculators), emotions – particularly fear and greed – trumps rationality, and thereby generates losses (“the appropriate toll”).

Assumptions of Extreme Rationality …

“Drawing on recent findings in both cognitive psychology and financial markets,” in Contrarian Investment Strategy (Random House, 1979), David Dreman demonstrated “how powerful and very destructive the tendency of people, even experts, to follow current fashions and trends can be” (see also Dreman’s two more recent books: Contrarian Investment Strategies: The Next Generation, Simon & Schuster, 1998 and Contrarian Investment Strategies: The Psychological Edge, The Free Press, 2011).

Dreman uncovered and explained “predictable patterns of behaviour, so predictable that it is possible to derive successful investment strategies (from them). In fact, numerous statistical studies … (since the 1940s) pinpoint overreactions in a systematic enough manner so that the investor applying these principles consistently will have a good chance of (outperforming those who overreact).”

Since the 1980s, rigorous research has repeatedly corroborated – and to my mind, none has challenged, never mind overturned – this insight (for a recent example, see Valeriy Zakamulin, “Stock price overreaction: evidence from bull and bear markets,” Review of Behavioral Finance, vol. 16, no. 6, September 2024).

It’s hardly a revelation: buyers and sellers in financial markets constantly face a relentless barrage of information. This torrent includes announcements of corporate results, releases of macro-economic data and myriad domestic and international events – and endless opinions about them and the future course of events.

Rigid and unrealistic – indeed, absurd – assumptions about the responses of speculators and investors to this information underpinned what was orthodox finance from the 1960s to the GFC. I criticise the crowd’s excessive emotion; in contrast, until recently academics praised their alleged lack of emotion!

The mainstream long insisted – and denounced and ridiculed anyone who questioned them – that buyers and sellers in financial markets aren’t prisoners of fear and greed. Quite the opposite: as a whole they always act efficiently and rationally. In particular, they immediately and accurately incorporate all available and relevant information into asset prices. Accordingly, collectively they never err systematically.

Markets, finance academics once decreed, are “efficient” because asset prices instantly and accurately incorporate ALL available information; as a result, securities’ prices ALWAYS reflect their fair – indeed, their true – value.

… Beget the Claim That “Bubbles Don’t Exist” – and Other Absurdities

The assumption of homo economicus, of robotically rational behaviour like Spock on Star Trek, underpinned this position. Rational choices are always subject to constraints such as limitations of means and time. Nonetheless, they’re consistent: if an individual prefers A rather than B, and also prefers B over C, he’ll prefer A rather than C. This behaviour has two key premises and implications:

1. Collective rather than individual rationality: even if some buyers and sellers occasionally act erroneously, imprudently or even crazily, the rational majority will quickly take advantage of their behaviour – by pushing securities and market indexes back to sensible levels.
2. No “excess returns:” when new information appears, prices shift accordingly; hence there’s no way consistently to “beat the market.”

If, as finance academics long insisted, financial markets are efficient, then value investors won’t – because they can’t – outperform the market. Academics never bothered to consider a contrary possibility: if value investors consistently outperform, then financial markets can’t be efficient as the academics claimed.

Above all, asserted the efficient markets orthodoxy, actors in financial markets are collectively rational. Hence their behaviour excludes fear, greed, irrational exuberance, folly, stupidity, panic and herd mentality; as a result, “bubbles” don’t – because they can’t – inflate.

Most notably, and even notoriously, is Eugene Fama. He’s been widely acknowledged as the “father of modern finance” (and co-recipient in 2013 of the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, which is ubiquitously mislabeled as “the Nobel Prize in Economics”).

In an interview with The New Yorker on 13 January 2010, he contended that an asset bubble, which he defined as an “irrational strong price increase that implies a predictable strong decline” is “not real” in the sense that it can’t be identified prospectively, or even in real time, but only with “20-20 hindsight” (for details, see Robin Greenwood et al., “Bubbles for Fama,” Journal of Financial Economics, Vol. 131, Issue 1, January 2019).

Value investors accept the obvious reality that actors in financial markets constantly face new information. Crucially, however, they recognise that markets are at best only roughly efficient. They know from long experience that they’re never perfectly efficient, and occasionally they’re crazily inefficient.

As early as the 1980s, Fischer Black, in an address to the American Finance Association, confessed a drastically weakened – and much more realistic – definition of efficiency. He thereby, and inadvertently, let out of the bag a key absurdity which underpins academic finance. He redefined an “efficient market” as “one in which price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value …” 

“By this definition, Black concluded, “almost all markets are efficient almost all of the time” (see “Noise,” Journal of Finance, vol. 41, issue 3, 1986). By this laughably lax “standard,” the S&P 500 Index’s level (almost 7,000 in January) was rational and efficient – and would also have been at either 14,000 or 3,500!

Mainstream academic finance was long unfalsifiable and thus clearly unscientific. Like today’s “climate science,” it was ideology, cloaked in mathematics and jargon, masquerading as science.

Value investors have long rejected the strictures of efficient markets orthodoxy. Graham concluded that in the short run the market is a “voting machine” (i.e., it’s swayed by emotion and thus, to that extent, inefficient), and that in the long run it’s a “weighing machine” (i.e., eventually corrects towards fair value).

Buffett’s attitude has been more critical. Investing in a market whose participants assume strong- and semi-strong efficiency, he told The New York Times Magazine (“Buffett Takes Stock, 1 April 1990), “is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.” “It has been helpful to me,” he added (“The $4-Billion Regular Guy,” The Los Angeles Times Magazine, 7 April 1991), that “tens of thousands (of students of business schools have been taught) it doesn’t do any good to think.” “You couldn’t advance in a finance department in this country,” he told The New York Times (“The Heresy That Made Them Rich,” 29 October 2005), “unless you taught that the world was flat.”

Charlie Munger’s assessment was harshest. “By and large,” he stated at Wesco Financial’s AGM in 2009, “I don’t think too much of finance professors.” The academic study of finance, he concluded, “is a field with witchcraft.”

“Semi-Weak” and “Weak” Efficiency

Are markets efficient? Yes – with the crucial caveat that the “strong” and “semi-strong” variants of the Efficient Markets Hypothesis are logically absurd and empirically false. What’s needed are far more realistic – that is, “semi-weak” and “weak” – variants.

What distinguishes actors in semi-weak and weakly efficient markets? They bear a much stronger resemblance to Ben Graham’s Mr Market than to Star Trek’s Mr Spock. To illustrate fundamental truths about stock markets, Graham used the parable of a business owner with an emotionally unstable partner. On many days, this partner, Mr Market will offer to buy your share of the business at a reasonable price. On others, however, he’d demand a ridiculously high price – and on still others he’d be desperate to sell to you for a song.

The value investor knows that occasionally he can profit from Mr Market’s excesses; mostly, however, he ignores them.

What distinguishes these “semi-weak” and “weak” variants of market efficiency? Sometimes – indeed, often – buyers and sellers don’t respond to new information. With the benefit of hindsight, they also often react incorrectly; they also “re-react” to (that is, reconsider the meaning and importance of) old news. Above all, they regularly respond inconsistently: sometimes “good” news has “bad” implications, and vice versa.

As Howard Marks observed (“Mr Market Miscalculates,” 22 August 2024), “an optimistic market is capable of ignoring individual pieces of bad news until a critical mass of bad news builds up, at which time a tipping point is reached, the optimists surrender, and a rout begins.”

Rudiger Dornbush’s quip about economics and finance is relevant in this context: “things take longer to happen than you think they will, and then they happen faster than you thought they could.” In The Sun Also Rises (1926), the American novelist, Ernest Hemingway, described this process. “How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually and then suddenly.” “What brought it on?” “Friends,” said Mike.

General economic theory (which subsumes EMH) assumes that your attitude toward risk remains stable throughout your life. A mounting body of evidence disagrees: in the real world, what you’ve experienced affects your willingness to bear risk. And the data which form that willingness is a mixture of recent history and formative experience (for details, see Don’t trust any “investor” under 30, 28 April 2025).

In the real world, as opposed to the fantasyland of tenured academics, most buyers and sellers are usually reasonably sensible. But they don’t generally respond immediately to information; nor do – or can – they typically respond accurately. Only a robot can utilise all relevant and exclude all relevant information. Only someone who’s omniscient can say what’s relevant and irrelevant – and, obviously, neither investors nor speculators are all-knowing.

Indeed, and as occurs during bear and bull markets, bubbles, crashes and panics, etc. – which most certainly exist – buyers and sellers often ignore or deny seemingly relevant information and incorporate obvious irrelevancies and delusions, and demonstrable falsehoods, into asset prices.

Speculators Err Systematically

Hence participants in markets (including professionals) and observers of markets (including journalists) regularly err systematically and thus roughly predictably. In particular, they routinely overreact to information (for details, see How “consensus expectations” harm your financial health, 13 October 2025, Why “faster and deeper” rate cuts likely wouldn’t lift shares, 21 July 2025 and How experts’ “systematic mispredictions” improve our returns, 6 August 2024).

Value investing therefore works because, as a group and in the short-term, most market participants – that is, speculators – overreact: they’re too optimistic on the upside and excessively pessimistic on the downside.

Moreover, speculators don’t merely overreact: they systematically overreact. In particular, they greatly overestimate the relevance of the present, extrapolate it into the indefinite future – and thus blithely ignore or flatly deny the fundamental reality that stocks’ returns are typically cyclical, and thus usually regress to their means.

As a result, buyers of “growth” stocks eventually experience negative surprises (that is, the disappointment and shock that accompanies loss); buyers of “value” stocks, in contrast, tend to experience the positive surprise of outperformance.

Graham Anticipated Behavioural Economics

In the 1930s and 1940s, Benjamin Graham – whom the academic finance orthodoxy long ignored – anticipated these results. When is a stock or a market cheap? When is it dear? When the ratio of price to its earnings (P/E) is large, he observed, buyers gladly pay a high price of $1 of earnings – and confidently anticipate that earnings will continue to grow quickly. Conversely, when a stock’s P/E ratio is small, buyers grudgingly pay a low price for earnings, and fear they’ll continue to languish or fall.

Half a century before the development of behavioural economics, which to a significant extent has overturned the previous “rational markets” orthodoxy, Graham offered a behavioural explanation for stocks’ P/E ratios. Cheap (“value”) stocks are unpopular and unfashionable; expectations regarding them – and thus their P/Es – are low. Expensive (“growth”) stocks are popular and trendy; hence their high P/Es reflect their buyers’ overconfident expectations.

Speculators mistakenly extrapolate into the indefinite future; in contrast, value investors cautiously regress to the mean.

Graham noted that stocks’ returns generally regress to their long-term means – but cautioned that this regression can often take several years or more to occur. “Under-valuation caused by neglect or prejudice,” he wrote in Security Analysis, “may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants.”

That insight was well worth bearing in mind during the Dot Com Bubble from the late-1990s to the early-2000s: in those years, value investors’ returns lagged well behind growth speculators’. Then came the Dot Com Bust and GFC – and growth crashed and greatly underperformed. 

For exactly the same reason, this insight is worth remembering today.

Over the past few years, value has again underperformed – and has thereby set the stage for its renaissance. Why? One reason, as I detailed in Figure 5 of Want to shrink your returns? Buy “growth” stocks! (23 March), is that value and growth stocks’ long-term returns are highly cyclical.

More fundamentally, there’s no reason to think that speculators will henceforth cease to do what they’ve always done: overreact confidently on the upside, and excessively despondently on the downside.

Since his death in 1976, Graham’s insights have been corroborated and elaborated. Perhaps most notably – and certainly most readably – in 1984 his most famous and successful student, Warren Buffett, rejected academics’ insistence that equity markets are efficient (see his speech and article entitled “The Superinvestors of Graham-and-Doddsville”). Buffett summarised the records of nine successful investors whose vehicles had over the preceding decades handily outperformed the Index; all were managed by Graham’s former students.

According to Seth Klarman (Margin of Safety, HarperCollins, 1991), “Buffett’s argument has never, to my knowledge, been addressed by the efficient-market theorists; they evidently prefer to continue to prove in theory what (has clearly been) refuted in practice.” Almost 40 years later, his point remains apt.

Why Value Investors Have Always Been and Will Always Be a Small Minority

Ultimately, and as I detailed Want to shrink your returns? Buy “growth” stocks! (23 March), the success of value investing rests upon a paradox. If it works, then why isn’t everybody a value investor? The answer is two-fold. Firstly, at key junctures value investors must necessarily be contrarians. They must, in Warren Buffett’s words, be “fearful when others are greedy and greedy when others are fearful.” Secondly, by their very nature contrarians – and thus genuine value investors – can never comprise more than a small minority of market participants.

As I noted, “as soon as sufficient numbers of people become interested in out-of-favour stocks, these stocks are no longer out of favour; and if enough people defy the consensus, they cease to be contrarians and become the crowd.”

Conclusion: Value Investing Works Because Returns Regress to Their Mean

As Thaler observed in Misbehaving, “it was not so much that anyone had refuted Graham’s claim that value investing worked; it was more that the efficient market theory of the 1970s said that value investing couldn’t work. But it did.”

Thaler acknowledged that Dreman was first person explicitly to explain Graham’s observation of what subsequently became known as the “value effect.”

Dreman’s research prompted Thaler and his colleague, Werner De Bondt, to suppose, in Thaler’s words, that the higher returns over the long term of low P/E stocks compared to high P/E stocks “is caused by overreaction: high P/E stocks, known as ‘growth’ stocks because they are going to have to grow like crazy in order to justify their high prices, have gone up ‘too high’ because investors have made overly optimistic forecasts of future growth rates, and low P/E (‘value’) stocks have sunk too low because investors are excessively pessimistic” (for details, see “Does the Stock Market Overreact?” The Journal of Finance, vol. 40, no. 3, July 1985).

“Companies that have been doing well for several years in a row,” Thaler continued, “gather an aura implying that they are ‘good companies’ and will continue to grow rapidly. On the other hand, those that encounter vicissitudes for several years “become tagged as ‘bad companies’ that can’t do anything right.”

“Think of it as a form of stereotyping at the corporate level. If (it) … is combined with the tendency to make forecasts that are too extreme, … you have a situation that is ripe for mean reversion” (see also How “consensus expectations” harm your financial health, 13 October 2025 and Everything the mainstream says about earnings is wrong, 13 March 2024).

“Those ‘bad’ companies,” Thaler concludes, “are not as bad as they look, and on average are likely to do surprisingly well in the future. If true, the subsequent high returns to value stocks and low returns to growth stocks represent a simple regression to the mean.”

Always disregarding and occasionally defying the consensus, over the past century value investors have bought from pessimists and eventually sold to optimists. Given optimists’ and pessimists’ (who’re the same people at different points in time) propensity to overreact, value investors have almost always experienced the satisfaction of consistently solid performance – and, usually, of outperformance.

As Buffett concluded in “The Superinvestors of Graham-and-Doddsville,” “ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”

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