At Betterment, your returns and peace of mind are at the center of our investing service. That’s why part of our fund selection process draws on the Fama-French investment model, which has shown that a slight tilt toward value and small-cap funds can help a portfolio outperform the market as a whole, over the long term. The Betterment portfolio has three funds which meet those criteria (see IVE, IWS, IWN).
Value tilting is based on the theory of value investing, the practice of buying securities that have been undervalued by the market and have low price-to-earnings ratio, for example. Some value picks will remain underwhelming, but for those that do break out, the returns can lead to market outperformance over time, research has shown.
However, it requires immense discipline for do-it-yourself investors to execute on a value strategy, especially at the individual stock level, says Columbia Business School finance professor Bruce Greenwald, also a member of Betterment’s investment committee. We recently spoke with Greenwald about how individual investors can benefit from a value strategy within their portfolios.
Why have a value tilt in a portfolio?
All the statistical studies show that historically, a value portfolio will outperform the market as a whole over long periods. It’s also true that if you look at the big money management firms, the value-oriented ones significantly outperform the others. Lastly, if you look at outstanding investors [Warren Buffett for example], they are disproportionately value-oriented investors.
Why does a value tilt out-perform?
The most important thing to never forget in investing is the Lake Wobegon effect. Only in Wobegon can people out-invest the market. The average performance of all investors has to be the average performance of all assets. It’s a zero-sum game if you judge it relative to the market. There are two sides to every trade. The best way to think about it is that every time you buy a stock, someone is selling. And generally one person is always wrong.
What is it that will put you on the right side of that trade? There are two ways that will work. One way is to specialize, where you know a stock or industry as an expert. Specialization is an obvious way to be on the right side, but there are almost no funds available on that basis. There are some industry funds, but they are a tiny portion.
The other way to do well is to take advantage of systemic irrational behaviors. People love lottery-ticket stocks and they don’t look carefully at ugly securities.
One reason a value portfolio outperforms is that while two-thirds of those stocks may do poorly, their purchase prices were so low that the one-third that does do well causes the portfolio to outperform.One reason a value portfolio outperforms is that while two-thirds of those stocks may do poorly, their purchase prices were so low that the one-third that does do well causes the portfolio to outperform.
Ugly aversion, or loss aversion, is a well-established pattern in behavior and means value stocks will be underpriced, unlike a lottery stock, or one that everyone is talking about such as Facebook or Amazon. People also think they know what they know with a high degree of certainty. People who believe in lottery stocks feel very certain they’re on the right side, but overconfidence accentuates that.
Is there a difference between “value investing” with individual stocks (finding those that are underpriced) vs. value-tilting an index portfolio?
Individual stocks are incredibly dangerous because you’re dealing with specialists on the other side of the trade. Don’t forget that two-thirds of value stocks crash and burn, so you don’t want a small portfolio. You want a well-conceived portfolio.
Is it even worth it for an individual with a 50- or 60-hour work week to be a value investor on their own?
No, that’s crazy. With amateur investors, their instincts are all wrong and most likely he or she won’t even do the cursory background, like reading the financials. The home-grown are just asking for trouble.
The second fact, which is where a portfolio brings value, is that there is a behavior penalty between portfolios versus individual stocks. One of the advantages of doing a fund is that there is a systematic process. When you’re doing it yourself and it’s going up, you’re going to hold on to it too long. And when it’s going down, you’re going to dump it too soon. That’s really why you don’t want to do individual stocks.
Should the individual investor, say with a less than $10 million portfolio, manage their own portfolio, with the expectation of beating an index fund? What advantage does the individual investor have?
You’re not going to beat an index fund. There is no advantage. You cannot as an individual take advantage of any specialization in a systematic way, like a fund can, because most people lack the discipline. Then there is the penalty for the behavior, and lastly, you’re just not going to be on the right side of the trade.
Greenwald is the academic director of the Heilbrunn Center for Graham & Dodd Investing at Columbia Business School and has authored several books including, Value Investing: From Graham to Buffett and Beyond.