Value versus Growth Investing

Although growth stocks have outperformed value stocks over certain time periods, this trend has not always prevailed over longer periods. For the two-year period 2003–2005, value stocks outperformed growth stocks, giving value stocks the appearance of being overvalued. Consequently, an investor looking for value might consider buying growth stocks because he or she would pay a small premium for them. Therefore, should investors continue to choose the leadership in the sector that is doing well and ignore the other lagging sectors of the market? It is easier to answer this question for a long investment period, but over the short term, it becomes more of a guessing game. The momentum investing style is to jump into those stocks that have been going up in price. The major problem with momentum investing is that the turning point can never be predicted accurately. These leadership stocks eventually will become laggards, and the rotation will shift into the other sectors of stocks. If one is investing in these leadership stocks at the top of their price cycles, the returns may be not be positive for some time before they come back into favor. Over the long term, investors who have diversified portfolios of stocks among the different sectors (small-, mid-, and large-cap value and growth stocks) will see steadier returns.

An analysis of the stock market substantiates this premise. Over the 26-year period 1979–2005, there were times where value stocks outperformed growth stocks and where the opposite occurred (growth stocks outperformed value stocks), as summarized in Table 13–2.

Which stocks over a long-term period would have returned more to investors? The answer may be surprising. A study done by David Leineweber and colleagues reported that $1 invested in both value and growth stocks, as followed by the price-to-book value of S&P 500 Index stocks during the period 1975–1995, would have resulted in $23 for value stocks versus $14 for growth stocks (Coggin, Fabozzi, and Arnott, 1997, p. 188). These results also have been confirmed by studies done on foreign stocks. A study done by Capaul, Rowley, and Sharpe (1993, p. 34) determined that value stocks outperformed growth stocks abroad (France, Germany, Switzerland, Japan, and the United Kingdom) during the period January 1981–June 1992. Jeremy Siegel, a professor at the University of Pennsylvania, found that value stocks outperformed growth stocks over the 35-year period between July 1963 and December 1998. Value stocks earned 13.4 percent annually, whereas growth stocks earned 12 percent annually (Tam and McGeeham, 1999, pp. C1, C19).

Table 13-2
Performance of U.S. Stocks Over the Period 1979–2005


In short, this phenomenon—value stocks outperforming growth stocks over long periods—should have some significance in the choice of stocks for investment portfolios. The evidence shows that winning stocks do not keep their positions over time; they revert to the mean. Similarly, losing stocks do not remain losers over long periods of time because they too rise to the average. In other words, the high-flying value stocks of today will not be able to sustain their abnormally high returns, and they will turn into stocks with lower returns, and the low returns of the growth stocks of today eventually will surprise investors with higher returns.

This phenomenon of returns reverting to the mean over time can be applied to small- and large-cap stocks as well. However, small-cap stocks outperformed large-cap stocks during the periods 1974–1983 and 1991–1992. Investing in small- and mid-cap stocks from 1996 to 2000 would have resulted in either below-market or negative returns. Inevitably, though, small-cap stocks outperform large-cap stocks on a risk-adjusted basis over long periods. The second reason to include small-cap stocks in a diversified portfolio is that small-cap stocks have relatively low correlations with large-cap stocks, thereby improving the risk/return statistics in a portfolio.

Adding mid-cap stocks to small- and large-cap stocks in a portfolio reduces the volatility risks and optimizes the stability of returns. Many market timers consider that this style of investing across different sectors weakens the potential returns they could have achieved by moving with the top-performing sectors. Obviously, a diversified portfolio will not gain as much as the strongest-performing sector or fall as much as the weakest-performing sector. The results for market timers depend on their accuracy in timing their calls to move in and out of the different sectors. Your overall choice of whether to be an active or a passive investor and your motivation for the choice of equity style ultimately will depend on your outlook on the market and your specific makeup with regard to risk and return.

Lack of Trading Plan
Planning plays a key role in the success or failure of any endeavor

Using too much Leverage
Determining the proper capital requirements for trading is a difficult task

Failure to control Risk
Refusing to employ effective risk control measures can ensure your long-term failure

Lack of Discipline
A lack of discipline can destroy even the most talented and best prepared trader

Useful Advices to Beginning Trader
You can control your success or failure

All about Stocks
Encyclopedia about Stocks. That you should know about Stocks before starting

Forex Glossary
All terms about Forex market