already shown that, because of its much higher mean return, the value
strategy’s higher standard deviation does not translate into greater down-
side risk. Second, the higher standard deviation of value stocks appears to
be due largely to their smaller average size, since the standard deviation of
size-adjusted returns is virtually the same for value and glamour portfolios.
But the results in table 8.3 suggest that, by focusing on larger value stocks,
investors could still get most of the extra return from value stocks without
this higher standard deviation. The extra return on a portfolio of large
value stocks cannot therefore be explained by appealing to its higher stan-
dard deviation. Finally, the difference in standard deviation of returns be-
tween value and glamour portfolios (24.1 versus 21.6 percent per year) is
quite small in comparison to the difference in average return (10 percent
per year). For example, over the 1926 to 1988 period the extra return on
the S&P 500 over T-Bills was approximately 8 percent per year, while the
average standard deviation on the S&P 500 was 21 percent compared to 3
percent for T-Bills. In comparison to the reward-to-risk ratio for stocks vis-
à-vis T-Bills, the reward-to-risk ratio for investing in value stocks is extremely
high. A risk model based on differences in standard deviation cannot explain
the superior returns on value stocks.
6 .Summary and Interpretation of the FindingsThe results in this chapter establish (in varying degrees of detail) three
propositions. First, a variety of investment strategies that involve buying
out-of-favor (value) stocks have outperformed glamour strategies over the
April 1968 to April 1990 period. Second, a likely reason that these value
strategies have worked so well relative to the glamour strategies is the fact
that the actual future growth rates of earnings, cash flow, etcetera of glam-
our stocks relative to value stocks turned out to be much lower than they
were in the past, or as the multiples on those stocks indicate the market ex-
pected them to be. That is, market participants appear to have consistently
overestimated future growth rates of glamour stocks relative to value
stocks. Third, using conventional approaches to fundamental risk, value
strategies appear to be no riskier than glamour strategies. Reward for bear-
ing fundamental risk does not seem to explain higher average returns on
value stocks than on glamour stocks.
While one can never reject the “metaphysical” version of the risk story,
in which securities that earn higher returns must by definitionbe funda-
mentally riskier, the weight of evidence suggests a more straightforward
model. In this model, out-of-favor (or value) stocks have been underpriced
relative to their risk and return characteristics, and investing in them has in-
deed earned abnormal returns.
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