We’ve discussed at length how asset prices are driven by changes in investor preferences for different cash flow profiles. I’ve explored this both here and here. In this post, I suggest those preferences are grounded in two psychological profiles: mean reversion (value) and trend (momentum).
The psychology of mean reversion assumes all things revert toward long-run averages over time. Today’s winners will win a little less. Today’s losers will win a little more.
The psychology of trend assumes winners keep on winning, and losers keep on losing.
The more time I spend with investors and savers of varying sophistication levels, the more I believe people are hardwired for one or the other.
Personally, I’m hardwired for mean reversion. It’s extremely difficult for me to extrapolate strong growth, earnings, or profitability into the future. It’s painful–almost physically painful–for me to own popular stuff that’s consistently making new highs. If I happen to be winning in the markets, it invariably feels too good to be true.
A trend guy is just the opposite. Why own stuff that sucks? he asks. Stick with what’s working. It’ll probably get better over time. If anything, you should be shorting the losers.
A popular misconception about value and momentum guys is that value guys buy “cheap” stuff and momentum guys buy “expensive” stuff. I used to think this way. And I was wrong. For a long time I fixated on the headline valuation multiples of the stuff each personality owned, totally ignorant of what was going on under the hood.
The value guy says:
This security is pricing such-and-such a set of expectations, which reflect the naïve extrapolation of present conditions. This, too, shall pass. When expectations re-rate to properly reflect the characteristics of the underlying cash flow stream, I will exit at a profit.
The momentum guy says:
This security is pricing such-and-such a set of expectations, but those expectations aren’t high/low enough. When expectations re-rate to properly reflect the characteristics of the underlying cash flow stream, I will exit at a profit.
Of course, there’s another guy relevant to this discussion. That’s quant guy. Quant guy steps back and thinks, “gee, maybe all these mean reversion guys’ and trend guys’ psychological dispositions impact security prices in relatively predictable ways.” Quant guy decomposes the mechanics of value and momentum and builds systems for trading them. Quant guy catches a lot of flak at times, but I’ll say this for him: he tends to have a pretty clear-eyed view of how and why a given strategy works.
In closing, I want to suggest all fundamentally-oriented investment strategies, whether systematic or discretionary, are rooted in the psychology of value and momentum. Both have been shown to work over long periods of time. However, they don’t always (often?) work at the same time. Arguably, this inconsistency is directly responsible for their persistence.
Put another way: value and momentum tend to operate in regimes.
And regimes deserve a post all their own.