If Factor Returns Are Predictable, Why Is There An Investor Return Gap?

Key Points

1. A large body of literature holds that the equity market premium is countercyclical and, using valuation ratios, is predictable.
2. The investor return gap persists, despite strong evidence that factor performance is mean reverting, because investors use the manager selection process for alpha timing.
3. Contrarian strategies enable stalwart investors to overcome the institutionalized behavioral biases that depress long-term returns.

Substantial evidence supports factor return predictability, yet evidence also indicates that investors are not reaping, to the greatest extent possible, the excess returns commensurate with such knowledge. A significant contributing factor to suboptimal investment results is the institutionalization of individual investor behavioral biases related to the confusion of short-term performance and manager skill as well as misplaced blame for poor outcomes. The good news...