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← Back to List2026.07.02#Philosophy#Asset Allocation

[Chapter 4] Exploiting Fear: The Discovery of the Value Factor ​

Proof of the Value Factor

An Index Fund Alone Cannot Manage Every Emotional Strain ​

Delving into the history of behavioral finance in Chapter 3, I realized an important fact: "The market is not perfect, and humans are infinitely frail in the face of public fear."

John Bogle's index fund is undoubtedly an excellent base camp, but it doesn't alleviate the psychological torment of your account halving when the entire market crashes wildly, like during Black Monday or the Financial Crisis. So I began to ask: "Didn't smart scholars in the past research how to increase defense and generate excess returns by exploiting the irrational overselling when the public dumps stocks in terror?"

Surprisingly, the person who provided this answer was the very man who built the temple of the Efficient Market Hypothesis (EMH) claiming "the market is perfect": Eugene Fama.

1. Eugene Fama Destroying His Own Temple: The Truth in 30 Years of Data ​

In the 1980s, headaches began to emerge in academia that irked Fama. "If the market is efficient, why do 'small-cap' and 'value stocks' consistently outperform the market average for decades?" At the time, mainstream academia dismissed this as an 'Anomaly' that could not be explained by existing theories.

To solve this mystery, Eugene Fama, along with his colleague Kenneth French, dug through a massive 30 years of US stock market data from 1963 to 1990. They sorted thousands of stocks based on 'size (market capitalization)' and 'value (book-to-market ratio)' and ran backtests to track the returns of each group.

In the study, adding size and value factors explained more of the historical return variation that the market factor alone did not capture. Explanatory power varies by sample and period and is not a forecast or guarantee of future returns.

Here, Fama's genius contrarian thinking shines. He mathematically embraced the public's fear and human irrationality during 'Black Monday' that we witnessed in Chapter 3.

"Value stocks beating the market is not because the market is inefficient. Value stocks are completely alienated by the public, harboring extreme 'fear' of impending bankruptcy. When the terrified public dumps excellent stocks at bargain prices like during Black Monday, the higher return is simply the natural reward (Premium) the market gives to investors who endured that horrifying 'fear and risk of ruin'!"

Boldly revising his past claims, he published a paper in 1992 declaring that stock returns are determined not only by market risk (Beta) but by two additional hidden DNAs (Factors). This is the birth of the famous Fama-French 3-Factor Model that changed investment history. (Note that 'Fama-French' is named after the last names of these two great scholars who made this profound discovery together.)

2. Decoding the DNA of Returns: Market, Size, and 'Value' ​

The three factors of stock returns they discovered are as follows:

① Market Factor

  • This is the fundamental risk borne by the entire stock market, and the basic return earned in exchange. (This is the basic return we get through an index fund.)
  • In fact, this factor was already proven to be great in Chapter 2 through John Bogle's Index Fund and the Efficient Market Hypothesis (EMH). It is that powerful first weapon which shows that simply owning the entire market, rather than making vain attempts to pick individual stocks, leads to long-term victory.

② Size Factor (SMB)

  • SMB (Small Minus Big) represents the return of small-cap stocks minus the return of large-cap stocks. It means that small-cap stocks have higher long-term returns than large-cap stocks.
  • As discussed in Chapter 3, liquidity and failure risks of small companies may be perceived more sharply during crises. One interpretation treats the size premium as compensation for such risk, but its cause and persistence remain debated. The finding later inspired me to separate a very small 'Future Mutation R&D Lab' satellite allocation.

③ Value Factor (HML)

  • HML (High Minus Low) is the return of high book-to-market stocks minus the return of low book-to-market stocks. A value premium appeared in the research sample, but superior performance is not assured across every market or period.

The Essence of Value Investing is 'Exploiting Human Psychology' ​

Fama and French's research goes beyond sorting accounting figures. It invites two broad interpretations: compensation for risk and the effects of investor behavior.

When bad news hits, investors may mark down even sound companies below estimates of fair value. Whether the value premium reflects behavioral mispricing or compensation for financial risk remains debated. Historical samples have shown return differences for groups of value stocks, but they do not guarantee excess returns for an individual stock or a future period.

The old adage "Buy low, sell high" had finally become science.

3. Smart Beta: The True Face of Genius Fund Managers ​

The emergence of this 3-Factor Model caused a massive paradigm shift in the investment industry. In the past, people worshipped fund managers who beat the market, saying, "That person is a genius at picking stocks." But looking through Fama's lens, the truth was underwhelming.

Some of a manager's performance could be explained not only by security selection but also by the portfolio's exposure to value and size factors. Factor exposure does not, however, explain every active result.

Studying this history, I slapped my knee. "Wait, then there's no reason to pay expensive fees to join an active fund? Can't we just run a computer algorithm (Quant) to mechanically filter out and buy only the stocks with high 'Value Factors' among S&P 500 companies?"

Research like this helped establish today's factor investing, which uses rules to target selected characteristics. For me, it later became a starting point for understanding the index rules behind SCHD.

Conclusion & Next Chapter Preview: How Will We Distribute These Weapons? ​

Through history, I gained two truths: The 'Market (Beta)' to defend against my ignorance, and the 'Value Alpha' to exploit the public's fear.

However, a problem still remained for practical investors in the 1990s. Even if they resolved to "use algorithms to filter and buy value stocks!", it was nearly impossible for an individual to manually find hundreds of those cheap stocks, adjust their weightings daily, and trade them. Even John Bogle's Vanguard Index Fund had a sluggish structure that traded only once a day.

A 'financial superhighway' was desperately needed to allow individuals to easily buy and sell these complex factor weapons in real-time, just like individual stocks, with the push of a button. And in 1993, a revolutionary system was born that solved all these distribution problems at once and engraved an indelible barcode in investment history. The story of building that infrastructure continues in Chapter 5. The Barcode of Innovation: The Birth of ETFs.

📚 [Evolution of Investment Series]

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