Factor investing often seems purely quantitative, driven by spreadsheets and backtests. But at its core, many factors—especially momentum and value—are powered by human behavior. Investors are not always rational, and these behavioral biases create patterns that factors systematically exploit.
In this blog, we’ll break down the psychological foundations behind momentum and value, and explain why these factors have delivered persistent returns for decades.
1. Why Psychology Matters in Factor Investing
Markets are driven not just by data and fundamentals but by human emotions—fear, greed, overconfidence, and herding behavior. These emotions often lead to predictable mispricings. Factors like momentum and value work precisely because they capitalize on these recurring behavioral mistakes.
2. Momentum: Riding the Herd
What is Momentum?
Momentum is the tendency of winning stocks to keep winning in the short to medium term (3 to 12 months), and losing stocks to keep losing. It’s one of the most well-documented anomalies in global markets.
The Psychology Behind Momentum
Underreaction to News
Investors often fail to fully incorporate new information, such as strong earnings or a major product launch, into stock prices. As the news gets gradually absorbed, the stock continues its trend.
Herd Behavior
Investors chase stocks that are already rising, amplifying the trend. This creates a feedback loop: rising prices attract more buyers, which pushes prices even higher.
Overconfidence and Anchoring
Traders anchor their expectations to past prices and underestimate new information. For example, they might think “this stock has already risen too much” and miss the continuation trend.
Real-World Example:
The Nifty 200 Momentum 30 Index has consistently outperformed the broader Nifty 50 over multiple 5-year periods, demonstrating how momentum captures these behavioral inefficiencies.
3. Value: Betting Against Overreaction
What is Value?
Value investing involves buying stocks that appear “cheap” based on metrics like Price-to-Earnings (P/E) or Price-to-Book (P/B) ratios.
The Psychology Behind Value
Overreaction to Bad News
Investors often overreact to temporary setbacks—such as disappointing quarterly earnings or regulatory hurdles—leading to sharp price drops. Value investors profit when these overreactions correct.
Loss Aversion
Investors hate losses more than they love equivalent gains. This fear often drives them to sell undervalued stocks prematurely, leaving bargains for patient value investors.
Neglect of Unpopular Stocks
“Hot” stocks get all the attention, while steady but boring companies (like utilities or mature industrial firms) are neglected, trading at discounts.
Real-World Example:
Despite long stretches of underperformance, value stocks have historically rebounded strongly during recoveries, as seen in the 2003-2007 and post-2020 bull runs in India.
4. Why Do These Factors Persist?
If these inefficiencies are well-known, why don’t they disappear?
- Human Behavior is Hardwired: Biases like fear, greed, and overconfidence are universal and persistent.
- Institutional Constraints: Many fund managers are forced to chase short-term performance, leaving long-term opportunities untapped.
- Career Risk: Few managers want to hold unpopular value stocks or chase momentum if it means diverging from benchmarks.
5. Combining Momentum and Value
Interestingly, momentum and value complement each other.
- Value tends to work well during market recoveries and long-term cycles.
- Momentum thrives in trending markets and periods of high sentiment.
A multi-factor portfolio blending value and momentum can balance the strengths of both, reducing drawdowns and improving returns.
6. Key Takeaways
- Momentum works because of underreaction and herding.
- Value works because of overreaction and neglect.
- These factors exploit timeless human biases, making them durable sources of return.
