Toward a theory of value investing: a behavioral perspective

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University of New Brunswick


We hear a lot about value investing, an investing approach introduced by Benjamin Graham in the 1930s and championed by Warren Buffett, but we know very little about why it works so consistently. Academia has considered the consistent performance of value investors as a statistical anomaly, but given that it has persisted for more than eighty years, it warrants further investigation. Currently, the higher yields obtained through value investing, which entails finding and buying stocks at a discount to their intrinsic value, is not explained by a body of theory. Furthermore, the complete works of Ben Graham have never been summarized in a systematic and analytical framework. This dissertation addresses both gaps. It summarizes the contribution of Ben Graham to the investment world; and, drawing on tools and concepts at the confluence of behavioral finance and the practice of value investing, my analysis and empirical studies contribute to building a formal theory of value investing. To provide context, the dissertation first focuses on the concept of rationality and explains the rationale of Prospect Theory as an alternative model of decision-making under risk, before tracing the evolution of value investing while highlighting the contribution of Ben Graham to security analysis. Additional literature reviews why value premium exists, mainly focusing on behavioral explanations. The theoretical aspects of value investing are then applied to two empirical examples. The first investigates the extent to which a value investing heuristic that is designed to minimize ‘gut’ decision-making and maximize analytical thinking can outperform other investment systems. The second demonstrates that over short holding periods, T-Bills and T-Bonds are safe assets in the sense that they always yield positive returns, however, over holding of periods five years or more, common stocks are just as safe and far exceed returns on T-Bills and T-Bonds. The major contribution of my dissertation is to lay a foundation for the theory behind value investing and to illustrate the reasons for its success through a careful and comprehensive review of the work of Ben Graham and the literature on behavioral finance. Lastly, the dissertation provides individual investors with a useful heuristic that reflects a value investing approach.