Bond investors have long been familiar with 'preferred habitat' theory. This is the idea that some investors prefer different types of bond: – pension funds, for example, want very long-dated ones while insurance companies prefer medium-dated ones. This means some bonds can become overpriced not because of speculative frenzy but because demand for them has increased from their particular client base. And they can stay overpriced because they are poor substitutes for other, apparently cheaper, bonds.
This should be well known. What’s not so well appreciated, however, is that 'preferred habitat' theory is also true for equities. This means that some types of share can stay systematically overpriced, and others underpriced, with the result that the latter outperform on average over the longer run.
For example, economists at AQR Capital Management have shown that bullish investors who cannot borrow much gear up their portfolios by buying high-beta stocks – ones that they expect to rise more than one-for-one as the market rises. Their preferred habitat for such stocks causes them to be overpriced, with the result that they underperform others on average. The AQR researchers show that this is true for US stocks, but it is also the case in the UK: my no-thought high-beta portfolio has risen only 46 per cent in the past 10 years while the FTSE 350 has almost doubled.