By: Richard Feldman, CFP, MBA, AIF
Most portfolios I have analyzed that were constructed by individual investors typically have one element in common; the largest asset class is typically allocated to large cap growth stocks. It seems that individual investors are very misinformed about asset class returns and how to construct an optimal portfolio because if you look at the raw data value stocks have outperformed growth stocks by a few percentage points over time. Are individual investors purposely shooting themselves in the foot? Surely that is not the case because what rational investor would choose a lower rate of return and higher volatility by choice? The answer is plenty!!!
Value Stocks versus Growth Stocks
How does one determine whether a stock is value or growth? Typically an index will be subdivided into value and growth subsets based on standard value measures such as price/earnings, price/book, or book/market ratios and define the lower priced half as “value stocks” and the higher priced or more expensive stocks as “growth stocks”
Large Cap Equity Returns
Looking at the long term returns of the Russell 1000 index which is a proxy for large cap domestic equities you will see that large cap value stocks have a much tighter distribution of returns than large cap growth stocks.
The chart above shows the annual returns of the Russell 1000 Value and Growth Indexes from 1979 – 2003. The average annual return for the Russell 1000 Value Index was 15.42% and the average annual return for the Russell 1000 growth index was 14.46%. A portfolio’s volatility is typically measured in terms of standard deviation and as you can see from the chart above the volatility of returns is wider for the Russell 1000 growth index. The chart translates into a standard deviation for the Russell 1000 value of 14.20% and 20.65% for the Russell 1000 growth. Volatility of returns has a direct impact on terminal wealth accumulation. The higher the volatility of returns the less terminal wealth you will build in a portfolio. Please see my paper on creating more portfolio value by minimizing risk.
Small Cap equity Returns
Now you might assume that this phenomenon only happens in large cap domestic equities but the data is consistent in both large and small stocks both domestic and international. Let’s take a look at the returns of the Russell 2000 index which is a proxy for small cap equities domestically.
Again you can see from the chart above that the distribution of returns is much tighter for the Russell 2000 value index than the Russell 1000 growth index. The annual average return for the Russell 2000 value and growth index is 17.28% and 12.9% respectively. Again you will notice from the chart above that the distribution of returns for the value stocks of the Russell 2000 is tighter which leads to a standard deviation of 14.20% versus 20.65% for growth stocks.
In developing an optimal portfolio one would not choose value or growth but choose a combination of both to maximize total return while minimizing volatility in a portfolio. Typically value and growth stocks shift leadership positions over different market cycles within the U.S. and globally. The numbers show that overweighting value stocks has led to higher portfolio returns with reduced volatility. The data used in this analysis was only twenty four years because it was based on the Russell 1000 index which dates back to 1979. Longer historical data is available via other indexes and the results are the same. There is a value premium that is consistent domestically, internationally, and in emerging markets as well, in both small and large equities. For some reason individual investors are building their portfolios in the exact opposite manner by overweighting growth stocks. Maybe they like lower returns and higher volatility but I doubt it.
|Jan 1979 – Dec 2003|
|Russell 2000||Russell 2000||Russell 1000||Russell 1000|
|Value Index||Growth Index||Value Index||Growth Index|