The New Finance
Summary
Haugen makes the case against efficient markets in a short volume that has gone through several editions, each updating the evidence. His subtitle in most editions calls it the case against efficient markets, and the structure follows that: state what the theory predicts, show data that contradicts it, then propose a behavioural explanation.
The central empirical claim concerns the value premium. Haugen shows that stocks with low prices relative to book value and earnings have outperformed expensive stocks over long periods and across markets. He then argues against the Fama and French interpretation that this compensates investors for distress risk, presenting evidence that cheap stocks have not been riskier by conventional measures and in some periods have been less volatile. His preferred explanation is that investors extrapolate recent earnings growth too far into the future, overpaying for companies with strong recent records and underpaying for weak ones, and that the correction happens as growth rates mean-revert faster than the market expects.
He supports this with evidence on the persistence of profitability, showing that high and low returns on equity converge more quickly than implied prices suggest, and with the low-volatility finding that also appears in his other work.
The argument was influential and much of it is now accepted, in the sense that behavioural explanations for the value premium are mainstream. The book itself is polemical, thin on the counterarguments, and dated in its data. Value's long period of underperformance after 2007 also complicates any confident claim that the effect is a permanent feature of investor psychology.
Key takeaways 7
- Cheap stocks have outperformed expensive ones across markets and long periods, which the efficient market hypothesis cannot explain without added risk factors.
- The value premium is not compensation for risk, because cheap stocks have not been more volatile or more distressed on average.
- Investors overestimate how long high growth and high profitability persist, and prices reflect that error.
- Profitability mean-reverts faster than market prices imply, which is the mechanism generating the value premium.
- The capital asset pricing model fails empirically because the relationship between beta and return is flat or negative.
- Behavioural explanations of return anomalies are testable and outperform risk-based explanations on the available data.
- Expensive growth stocks earn low returns because expectations embedded in their prices are systematically too high.
Who should read it
Investors who want the behavioural case for value investing argued against the academic risk-based interpretation, with the caveat that the data stops before value's long drawdown.
About Robert A. Haugen
Finance professor at the University of California, Irvine and a persistent critic of the efficient market hypothesis; died in 2013.
The New Finance argues that the value premium comes from investors extrapolating past growth rates too far rather than from bearing extra risk, contradicting the risk-based explanation Fama and French offered. The Inefficient Stock Market assembles the cross-sectional evidence, including the low-volatility result that factor products were later built on.
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