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Biased to bubbles

This de-rating of an erstwhile 'growth' sector is nothing new: remember tech stocks? In fact, it conforms to a longstanding pattern for growth stocks - those on low yields - to underperform 'value' stocks. Since 1986 the FTSE low yield index has returned 2.3 percentage points less per year than the high yield index despite the fact that falling long-term yields should have boosted growth stocks. The UK is not unusual in this. Cliff Asness and colleagues at AQR Capital Management have estimated that there has been "a significant return premium for value" in the US, Japanese and European equity markets since 1972.

This poses the question: why do investors so often pay too much for growth stocks? I suspect it is because a number of cognitive biases combine to cause them to do so.

One of these is what Nobel laureate Daniel Kahneman has called the most damaging of biases - overconfidence. We exaggerate our ability to spot future growth and fail to see that, as Sussex University's Alex Coad has said, corporate growth is in fact a "fundamentally random process" - a claim corroborated by US economists who have found that "there is no persistence in long-term earnings growth beyond chance."

Related to this is the planning fallacy - our tendency to under-estimate the difficulties of any complex project. Remember a key fact about companies: big ones are very rare. Of the 2.44m companies in the UK, only eleven are worth more than £50bn. That's less than one in 200,000. This warns us that there are massive obstacles to growth. Companies must overcome diseconomies of scale, keep rivals out of profitable markets, avoid being undermined by disruptive technical change, implement expansion plans competently, and so on. Very few can do all this. But investors over-estimate their chances of doing so.

A third bias is a version of the narrative fallacy. One way in which we reject the importance of randomness is to tell ourselves stories which give the impression of predictability. The tech bubble was inflated by talk of a new economy and mining stocks by talk of a commodity supercycle.

Fourthly, there's wishful thinking. As the University of Melbourne's Guy Mayraz has shown, our interests colour our beliefs. Once we've bought a stock, we find lots of reasons to expect it to rise.

This is reinforced by a fifth error - the confirmation bias. Once we believe something, we interpret ambiguous evidence as supportive of it and underweight contrary evidence. This can cause us to stick with stocks that seem overpriced by conventional criteria.

All this poses the question: why don't wiser investors bet against all these biases?

Because it's difficult. There is often wisdom in crowds so it makes sense to at least sympathise with them. To do otherwise requires immense arrogance. It can also be very expensive. The investor who bet against mining stocks would have lost money for much of the last decade. In investing, it is not good enough to be right - you have to be right at the right time, which is much harder.

Perhaps, therefore, a tendency for there to be occasional bubbles in growth stocks is an ineliminable feature of markets, because they are rooted in so many very common mistakes.