Investopoly Why value investing will deliver higher returns with lower risk
I’m a big advocate of value investing. If you buy high a quality investment for fair price and hold it for the long run, you can’t help but make a lot of money. But if you can buy the same quality asset cheaply (below its intrinsic value), then it’s likely that you will make even more money. This is what value investors attempt to do.
You can adopt a value investing approach with many asset classes, which I’ll discuss later. However, for most of this blog, I’ll use shares as an example because there’s a lot more data available.
How does value investing reduce your risk?
When investing in an asset, you can derive an investment return in two ways; by receiving income and/or the value of the asset appreciates i.e., capital growth. Often, assets provide a combination of both income plus growth.
Receiving income is less risky because you ‘bank’ the return each year. That is, you are less reliant on capital growth to generate an acceptable overall return.
Your capital return will depend on two factors. Firstly, what you paid for the asset (to purchase it). And secondly, the assets future value. Of course, overpaying for the asset initially will diminish future capital returns. Overpaying slightly for a high-quality asset probably won’t have a material impact on future returns, as a quality assets growth with quickly make up for any small overpayment. But a material overpayment and/or buying a poor-quality asset is a big problem that will cost you dearly.
Conversely, if you buy a quality asset for a cheap price, you are less reliant on the overall market organically driving prices higher to generate quality returns. In fact, in this situation, your future capital growth will come from two sources: the appreciation to fair market value, plus organic growth.
A quick history lesson…
The chart below compares how value has performed compared to growth in the US share market since 1979 (using the Russell 1000 indexes). They have performed similarly over the long run i.e., growth has returned 11.3% p.a. and value 11.6% p.a. However, recent performance has been a lot different. Between 2018 and 2021, growth substantially outperformed value as it returned 24.1% p.a. versus 10.5%. Consequently, by historic standards, value is now relatively cheap.
Why do I think value is likely to outperform over the medium term?
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