I have previously said here “I personally think that the key to explaining what is wrong with the market lies in agency theory.”. I will elaborate on this (I was sure I had done so previously, but cannot find anything).
Pretend you are a fund manager. You do not want to take too much of a risk that you will under-perform really badly and get fired, so you do some closet tracking with most of the fund. That’s your core, so what about the satellite?
What you need is something with the potential to get spectacular performance, reasonably soon. Value investing is likely to out-perform, but over the long term. Use an approach like this, and by the time your out-performance is good enough to make you a significant amount of extra money, you will be most of the way to retirement.
So, what you do is try to pick shares that will perform really well over the next year or two. That usually means growth.
Add to this that active investors in general (whether investing their own money or other people’s), are more likely to be risk-loving than the population at large — otherwise they would be passive investors. I do not mean that all active investors are gamblers, but that the proportion of gamblers is higher among active investors.
We can explain the value effect as the result of investors not being consistently risk averse, as CAPM assumes (in fact CAPM assumes a particular form to the risk aversion). As I have said before, this is a dubious assumption, but the correct formula will be something similar to CAPM.
In fact, if CAPM fails to explain prices because some investors are risk lovers, it is all the more reason to think that it is a good way for risk averse investors to value securities. If something better comes along, I would be quite happy to switch to it.
None of this affects the efficient markets hypothesis, or any of the other fundamental assumptions of financial theory (such as no arbitrage). Some people take too high a risk, often with other people’s money, which gives the rest of us some opportunities.