One of my friends recently cashed in a variable annuity. He bought it years ago, before he realized it was a high-cost rip-off. “I want to invest the proceeds,” he said. “What do you recommend?” He already owned one of Vanguard’s Target Retirement funds. These are complete portfolios of indexes rolled into a single fund. They’re diversified. They charge low fees, and they get rebalanced once a year.
I thought he should add the proceeds to this fund. But he wanted to add some icing to his cake. He liked Vanguard’s U.S. Growth Index. Over the past 10 years, it averaged a compound annual return of 12.46 percent. That would have turned a $10,000 investment into $32,357. It beat the S&P 500. It also beat value stocks. Over the same time period, $10,000 in Vanguard’s Value Stock Index would average a compound annual return of just 9.87 percent. It would have grown to $25,632.
High-flying tech companies have pushed growth stocks up. Many people (especially new investors) are rushing in to buy. But plenty of smart investors are moving the other way. Savvy investors, ironically, think more like rats than people.
Leonard Mlodinowis is the author of The Drunkard’s Walk, How Randomness Rules Our Lives. In his book, the physicist describes an experiment where people competed against rats. Subjects were shown a flashing light. Sometimes it was red. Other times, it flashed green. Before the test began, the rats and the people watched the lights for a while. The red light flashed twice as often as the green.
That’s why most of the rats picked red every time. Most of the people, however, looked for flashing patterns. As a result, the rats trounced them. So, what does this have to do with growth and value stocks?
Value stocks are like that flashing red light. I measured small-cap, mid-cap and large-cap stocks. Over the past 45 calendar years, value beat growth 62.2 percent of the time. I also divided the time into nine 5-year periods. When value stocks won, they did so by a compound annual advantage of 4.87 percent. When growth stocks won, they beat value stocks by a compound annual advantage of just 1.72 percent.
Over the entire 45-year period, value stocks averaged a compound annual return of 13.52 percent. That would have turned a $10,000 investment into $3,241,880. In contrast, growth stocks averaged a compound annual return of 11.59 percent. That would have turned the same $10,000 into $1,339,070.
Value Stocks Usually Give Growth A Beating
|5-Year Compound Annual Return||5-Year Compound Annual Return|
|2014-August 31, 2018||10.39%||11.91%|
|1974-August 31, 2018||13.82%||11.59%|
|Growth of $10,000||$3,241,880||$1,339,070|
|Source: portfoliovisualizer.com; Splitting each factor three-ways: small cap, medium-cap, large-cap|
Growth stocks are sexy. They’re often story-book companies that we think will change the world. And many of them will. But such optimism brings a high-price tag. Growth stocks trade at higher earnings multiples. Value stocks are usually about one-third cheaper.
But compared to growth stocks, value stocks might be cheaper today than they have ever been before. In 2017, Columbia finance professor, Kent Daniel said the typical value stock was 50 percent cheaper than the average growth stock. By September 2018, the price gap widened further.
Plenty of investors try to time growth and value. They dance from one to the other when they think they see a winner. Savvier investors think more like rats. They stick to value, much as they might with that flashing red light.
Other smart investors rebalance between growth and value. During calendar years when value stocks soar, they skim from the proceeds, adding money to growth. When growth stocks soar, they do the opposite. Such a strategy might reduce risk, and it sometimes boosts returns.
My friend says he doesn’t have such discipline. In that case, he should stick to his target retirement fund. But if he wants to add a bit of icing to that cake, it might serve him well to channel his inner rodent.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas