Value investing: Can you withstand the pain?

Value investing: Can you withstand the pain?

July 31, 2014 Architect Academic Insights, Value Investing
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So the market took a tumble today–Feeling pain? Feeling emotional? Expecting the downward trend to continue?

Be careful, your system 1 is terrorizing your ability to make effective decisions.

To put a -2% day in perspective, let’s review some history related to value investing…

Defining a simple value investor

We define a value investor as one who buys low-priced stocks.

Being a value investor has the intuitive appeal of “buying cheap stuff.”

Additionally, numerous academic papers have shown the persistence of the “value” premium, which Fama and French famously documented in their 1992 JF and 1993 JFE papers.

So why isn’t everyone buying cheap stocks?

Being a value investor requires some patience and faith that market overreactions will eventually be corrected.

In theory, value investing is easy: buy and hold cheap stocks for the long haul.

In practice, value investing IS ALMOST IMPOSSIBLE.

Using Ken French’s data, we examined some time periods where it was painful to be a value investor.

One such period is during the run-up to the internet bubble. We examine the returns from 1/1/1994-12/31/1999 for a Value portfolio (High B/M quintile, VW returns), Growth portfolio (Low B/M quintile, VW returns), Risk-Free return (90-day T-Bills), and SP500 total return.

2014-07-29 15_43_16-Microsoft Excel - EQV_including_dispersion_analysis_v01.xlsm
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Talk about a beat-down! Looking at the annual returns, value investing lost every year to a simple market allocation!

2014-07-29 15_45_59-Microsoft Excel - EQV_including_dispersion_analysis_v01.xlsm
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Looking back, we now realize that the internet bubble was about to burst, but at the time, value investing was getting criticized.  Warren Buffett, arguably the greatest value investor, was criticized in the media for “losing his magic touch.” After the fact, it is obvious that value works, but truly ask yourself:

COULD YOU STICK WITH AN INVESTMENT THAT LOST 6 YEARS STRAIGHT TO THE MARKET?

If you did have the discipline and commitment to value investing you were rewarded.

Here are the returns to the same portfolios from 1/1/2000 – 12/31/2013:

2014-07-29 15_58_14-Microsoft Excel - EQV_including_dispersion_analysis_v01.xlsm
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

For the next 14 years, value investing was the better bet (we have documented this before).

Here are the results over the entire time period from 1/1/1994 – 12/31/2013:

2014-07-29 16_01_28-Microsoft Excel - EQV_including_dispersion_analysis_v01.xlsm
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

So while over the entire time period, value investing was optimal, there can be long periods of time (up to 6 years!) where you underperform.

Ask yourself again–and be honest:

Can you withstand the pain of value investing?

Said a different way:

Can you lose for 6 years and stick to the program?

Most of us simply cannot suffer that amount of pain as individuals. And for those of us in the investment advisory business, peddling a strategy with the potential for multi-year underperformance is akin to suicide (and yet, this is exactly what we do as value investors…maybe we need to check ourselves in to the asylum!)

A -2% day? A big deal? Well, things can get a LOT WORSE!

There is one person who can stick with the program and he’s smiling all the way to the bank!

 

 

 

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About the Author

Jack Vogel, Ph.D.

Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.