and size effects we see in the historical data, another assumption needs to
be added: that price movements caused by these liquidity traders are not
immediatelyreversed by those trading on fundamental information.
This assumption is a deviation from the efficient markets hypothesis
that claims that at all times the price of a security is the best unbiased esti-
mate of the underlying value of the enterprise. I have called the alternative
assumption the “noisy market hypothesis” because the actions of noise or
liquidity traders often obscure the fundamental value of the firm.^29
The noisy market hypothesis can provide an explanation for the
size and value effects.^30 A positive liquidity shock raises the price of the
stock above its fundamental value and makes that stock more likely to
be classified as a “large” or “growth” stock. When this positive shock
disappears, these large growth stocks decline in price and thus have
lower returns. On the other hand, a negative liquidity shock lowers the
price and makes it more likely a stock will belong to the “small” or
“value” category, which is likely to be underpriced relative to its funda-
mentals. When the negative shock disappears, these value stocks have
higher returns.CONCLUSION
Historical research shows that investors can achieve higher long-term
returns without taking on increased risk by focusing on the factors relat-
ing to the size and valuation of companies. Dividend yield has been one
such factor and the price-to-earnings ratio has been another. Over time,
portfolios of stocks with higher dividend yields and lower P-E ratios
have outperformed the market more than would be predicted by the ef-
ficient markets hypothesis or the capital asset pricing model.
Nevertheless, investors should be aware that there is no strategy
that will outperform the market all the time. Small stocks exhibit peri-
odic surges that have enabled their long-term performance to beat that
of large stocks, but most of the time their performance has fallen behind
large stocks. Furthermore, value stocks have tended to do very well in
bear markets, but often underperform growth stocks in the latter stages
of bull markets. This means that investors must exercise patience if they
decide to pursue these return-enhancing strategies.CHAPTER 9 Outperforming the Market 159
(^29) See Jeremy Siegel, “The Noisy Market Hypothesis,” Wall Street Journal, June 14, 2006.
(^30) See Robert Arnott, Jason Hsu, Jun Liu, and Harry Markowitz, “Does Noise Create the Size and
Value Effects?” unpublished manuscript, September 2006.