Buying cheap, unloved stocks during roaring bull markets demands a gut check. This year, hold the antacid tablets, so-called value investors look pretty smart.
The Russell 1000 Value index is up 12% so far in 2016, more than double the return of the SP 500 . The Russell 2000 Value did even better, with a 24% return year to date.
Numerous studies show that over the long term, total returns of value stocks exceed total returns of the stock market. But it’s maintaining confidence over that long stretch that exposes the emotional vulnerabilities of the average investor, and can batter their portfolios. After all, there are periods of suffering – several periods of suffering as the strategy plays out.
For example, the SP/Citigroup Pure Value index performance in 2015 was dismal, worse than the SP 500. The index also underperformed in 2014 and 2013, possibly prompting many to give up on the strategy.
Here’s a chart of rolling, two-year total long-only return spreads between a value approach and the broader market from 1929 to 2015 from Wesley Gray, chief investment officer at Alpha Architect, using data from professor Kenneth French of Dartmouth College.
The chart shows that investors will have to live through the years of pain to achieve long-term outperformance.
In a blog post, Gray didn’t hold back: “Value investing is quite possibly the worst decision you will ever make – even at the current relative spreads. The pain will be unbearable and you will be forced to sell. Therefore, value investing is quite possibly the worst idea…EVER.”
Does that mean people should NEVER invest in value? Of course not. But if you fall under any of the categories below, most advisers would tell you to stay clear of the strategy.
1. You’re planning on retiring and using your income over the next 5-7 years
Value investing pays off over the long time, but if you are ready to withdraw money soon, you might be taking a tremendous amount of risk.
2. Your investment is modest and you rely on it for your retirement
Taking risk is not for people of modest means. Putting a portion of a portfolio into a value bucket is great if you can afford to bet on unpopular things that are known to stay undervalued for years. But seeing your only nest egg constantly bleeding money is troubling for most investors. It is better to have a diversified portfolio of low-cost index funds and save as much as possible.
3. You have a long horizon, but are severely risk averse
Steady-but-small returns and sleeping well at night carry their own “value” and aren’t always the best exchange for a potential reward in a distant future. Selling at the wrong time will rob you those future returns.
4. You’re a portfolio manager whose performance is measured against a benchmark like the SP 500
“Value investing has been digging graves of portfolio managers for more than 100 years,” said Gray, in a post. An active manager’s portfolio may see years of underperformance resulting in losing his or her job. When choosing mutual funds, the vast majority of institutional and retail investors pick managers who did well recently. So, value funds have a harder time obtaining and retaining clients.