Explaining The Value Premium

The existence of a value premium—the difference in returns between high book-to-market stocks and low book-to-market stocks—has been well-documented. However, there’s a major controversy as to its source.

Some believe it can be explained by risk—that value stocks are the stocks of riskier companies. On the other hand, behavioralists believe the premium results from pricing mistakes—that investors tend to persistently overprice growth stocks and underprice value stocks.

Digging Into The Research

Recently, I was discussing this puzzle with a friend, which led me to dig into my files to review the literature. Among the papers I thought were of interest was “The Value Premium and Economic Activity: Long-run Evidence from the United States.”

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