Old Dominion University's Quest
Those who believe that capital markets—that is, markets for stocks and bonds—operate efficiently and asset prices fully reflect all publicly available information are engaged in an ongoing debate about the exact interpretation of the “value premium” with those who reject this view. Value premium refers to the superior returns generated by the purchase of value stocks relative to growth, or glamour, stocks. Rationalists, the group believing in market efficiency, argue that because value stocks are fundamentally riskier than growth stocks, the value premium is compensation for bearing risk. Behavioralists, the group arguing that market asset prices don’t reflect all publicly available information, however, claim that value stocks produce higher returns mostly because investors consistently overestimate the future earnings of growth stocks relative to value stocks. The essence of this argument is that investors are excessively pessimistic about value stocks because they tie their earnings expectations to past earnings. That is, investors make systematic errors in predicting future growth in earnings for value stocks, and investors’ excessive pessimism about these stocks causes the superior performance of value stocks relative to growth stocks. This behavioral explanation of the value premium is known as the “extrapolation” or “errors-in-expectations” explanation, and many researchers support it.
Original Publication Citation
Doukas, J. A. (2006). Divergent opinions and value stock performance. Old Dominion University's Quest, 9(1), 32-34.
Doukas, John A., "Divergent Opinions and Value Stock Performance" (2006). Finance Faculty Publications. 18.