Why Value Stocks are Better Investment than Growth Stocks

According to Investopedia, a value stock is one that “trades at a lower price relative to its fundamentals,” and a growth stock is one that “is anticipated to grow at a rate significantly above the average growth for the market.” Value stocks, by definition, underperform and take time to regain lost ground; whereas growth stocks often outperform the market because of the expectation for high growth. For that reason, value stocks are often considered to be unpopular.

I, however, argue that value stocks are better investment than growth stocks. Yes, growth stocks often enjoy stronger upward price movement. However, as I pointed out in another post, the price increases can be a result of irrationality of investors, such as extrapolating future growth from past records and herd mentality. Hence, the support for price growth would quickly crumble when companies fail to meet expectations. In other words, growth stocks potentially have more room for price drop than increase. In comparison, value stocks suffer from heavier selling pressure than they deserve due to similar market irrationalities. As a result, they could enjoy more potential for price increase than decrease.

In the rest of this post, I will first illustrate how inappropriate comparison methodology could lead to misleading conclusions about asset performance. It is followed by discussion about the appropriate way of comparison. Lastly, I compare the performances of value and growth stocks. Evidence shows that higher average return rate or maximum return rate does not necessarily make growth stocks a better investment. Instead, thanks to lower volatility, value stocks could outperform growth stock in different market conditions.

1. Comparison of Performance

1.1 The Wrong Way of Comparison

ETFs such as iShares Russell 1000 Value ETF (IWD) and iShares Russell 1000 Growth ETF (IWF) focus on value stocks and growth stocks in a specific index. In the rest of the post, I will use IWD and IWF to represent value stocks and growth stocks, respectively. Even though they are not perfect, they should be representative enough to show the differences between value and growth stocks.

The Chart 1 below shows that the growth stocks in the Russell 1000 index have consistently outperformed value stocks in the past 5 years.

Chart 1. Value Stocks vs Growth Stocks (5 year)

However, to the trained eye, this chart does not really compare the performances between the two assets. Rather, it only compares the price levels of each asset with itself between two time points (in this case, in 5 years)! In other words, the time frame picked for comparison, not assets themselves, can affect our conclusion. For example, if we trace the assets back to the year of 2000, the chart (Chart 2) would like this:

Chart 2. Value Stocks vs. Growth Stocks (20 years)

Chart 2 shows the opposite picture. Not only have value stocks outperformed growth stocks, but also the two charts show totally different patterns for the two assets since August 2015. In Chart 1, there was little difference between the two assets before 2017 and growth stocks outperformed value stocks since then. But in Chart 2, value stocks outperformed growth stocks until early 2020!

The reason why the same data can be used to prove two opposite conclusions is that the type of these charts is not designed to compare the performances of the two assets! Unfortunately, marketing or sales professional often use data manipulation trick like this in their sales pitches.

1.2 The Correct Way of Comparison

A more accurate comparison is to focus on periodical (monthly or quarterly) rates of return. Chart 3 below shows monthly price growth rates of the two assets from May 2000 to August 2020 (Note that the approximate differences in growth rates between the assets can also be seen in the different slopes of the curves in Charts 1 and 2).

Chart 3. Monthly Growth Rates of Value and Growth Stocks

By simply looking at the chart, one could see that (1) the changes in the growth rates of the two assets follow a similar pattern. In fact, for technical readers, the correlation of their growth rates is as high as 0.83! (2) The fact that the growth stock line (blue) often shoots higher/lower than the value stock line (orange) indicates that growth stocks are more volatile than value stocks. And the higher the volatility, the riskier the asset is.

2. The Real Comparison: Risk vs. Return

Let’s first compare the return between value stocks and growth stocks (Table 1). Positive average monthly growth and median growth rates indicate that value and growth stocks grow in most months of the time period. Looking more closely, because of the reasons discussed at the beginning of the post, growth stocks see slightly higher growth than value stocks. Nonetheless, the data also show that growth stocks have higher volatility (standard deviation) in growth rates. High volatility should be a major concern for investors.

Value StocksGrowth Stocks
Average Growth Rate per Month0.41% 0.51%
Median Growth Rate per Month0.92%0.93%
Volatility (Standard Deviation)4.33%4.86%
Table 1. Summary Statistics of Value and Growth Stocks

What’s bad about high volatility?

So, what’s bad about high volatility (risk)? Don’t people say “the higher the risk, the higher the return?” High volatility could result in volatility drag. I’ll use two examples to show the impact of volatility drag. There are two hypothetical Assets A and B in two time periods (Table 2). Asset A has higher maximum return and the average rate of return than Asset B (average return of Asset A = [100% + (-50%)] / 2 = 25% ). Thus, Asset A seems to be a better investment between the two.

However, Asset A also has 20% higher volatility than Asset B. Now, if we invest $100 in Assets A and B at the same time, then we will find that our account balances will change to $200 and $180 respectively at the end of Period 1, which is good. But when the prices drop during Period 2, our balances drop back to $100 for Asset A and $120 for Asset B. So, at the end of the day, despite higher average rate of return, we earn $0 on Asset A but $20 on Asset B! If we calculate cumulative rate of return of our investment, the rate for Asset A is 0% and that for Asset B is 20% (cumulative rate of return for Asset B = ($120 – $100) / 100 )!

As we can see from this example, high volatility (risk) assets don’t really generate higher return than low volatility assets! Instead, higher volatility only “drags” down your return during market downturns.

Asset A
Return Rate
BalanceAsset B
Return Rate
Balance
Investments100100
Period 1100%20080%180
Period 2-50%100-40%120
Average Return25%20%
Cumulative Return0%20%
Table 2. The Impact of Volatility on Asset Returns

The example above starts with growth and ends with decline. Let’s take a look at an opposite scenario where the market goes through a plunge and is followed by a jump (Table 3). In this scenario, Asset A still has higher average return rate and volatility than Asset B. And we still invest $100 in them. The only difference is the sequence of market events.

At the end of market crash in Period 1, Asset A has $50 left in the account and Asset B has $60. After a magnificent run in Period 2, Asset A doubles its balance back to $100 and Assets B has an 80% jump to $108, still higher than Asset A! Regarding the cumulative return rates of the two assets, Asset A has an unfortunate 0% despite higher average return rate and higher maximum return rate; while Asset B, the seemingly worse investment has a cumulative return of 8%.

With lower average return but lower volatility, Asset B beats Asset A in both scenarios. Thus, lower volatility is more valuable than higher average return rate!

Asset A
Return Rate
BalanceAsset B
Return Rate
Balance
Investments100100
Period 1-50%50-40%60
Period 2100%10080%108
Average Return25%20%
Cumulative Return0%8%
Table 3. The Impact of Volatility on Asset Returns

3. Conclusion

As we can see, when compared correctly, growth stocks tend to have higher average return rate and maximum return rate than value stocks. Nonetheless, that does not make growth stocks a better investment due to its higher volatility. On the one hand, growth stocks can benefit from higher return rates in favorable market conditions; on the other hand, they suffer more when market conditions reverse due to high volatility.

Since it is rather irrational to expect non-stop growth of any company and it is nearly impossible to time market downturns, the positive average return rate plus lower volatility of value stocks makes it a better investment than growth stock.

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