Asset Allocation Guide: Value vs. growth
The asset allocation process is somewhat like a Russian nesting doll. What appears as a sole, simple object actually comprises a great deal. Like each doll, one after the next, a portfolio consists of detailed, intricate workings.
We’ve already seen this in earlier articles in our asset allocation series, where we covered some essentials, namely, how to analyze your ability, willingness and needto take risk — and what do when one or more of those factors conflict. After our most recent discussion about domestic vs. international stocks as part of your equity allocation, we’re now moving into another important allocation choice investors need to make: the value stocks vs. growth stocks decision.
When thinking about the guidelines below, remember that a “market” portfolio is completely neutral with respect to value and growth exposure. It’s neither value- nor growth-tilted.For investors who go with a value-tilted portfolio, most choose to do so for one of three reasons. They believe:
1. Value stocks are riskier than growth stocks. Therefore, value stocks should provide a risk premium in the same way that equities should provide a risk premium over the return of safer fixed-income investments. This is the traditional finance point of view.
2. Value stocks aren’t riskier than growth stocks. They believe other investors systematically overprice growth stocks and underprice value stocks. The value premium is a free lunch, not a risk premium. They argue that value stocks provide superior risk-adjusted returns compared to growth stocks. This is the behavioral finance point of view. Behavioralists use the Internet and technology bubble of the late 1990s to bolster their argument.
3. Both traditionalists and behavioralists are partially right. Value stocks are riskier than growth, but the risk premium has been too large to be explained by the excess risk. While it may not be a free lunch, it just might be a free stop at the dessert tray.
We’ll assume the traditional finance view of the value premium being a risk story, but it’s helpful to be aware of all viewpoints.
Reasons to increase value exposure
Increased expected return with increased risk: From a traditional finance point of view, investors should tilt toward value if they need to increase the expected return of their portfolios to meet their goals — but only if they’re willing and able to accept the incremental risk of value stocks.
Diversification of sources of risk: Consider an investor needing a certain rate of return to achieve his goals. That rate of return can be achieved with a certain exposure to beta (total stock market) risk. The appropriate allocation to the total market (which has no value exposure) might be 60 percent. Another way to achieve the same goal is to lower the exposure to beta (50 percent), but add sufficient value exposure so the two portfolios have the same expected return. Historically, the value-tilted portfolio with a lower exposure to beta has exhibited less volatility. The reasons are that the value premium has been less volatile than the equity premium and has low correlation to the equity risk premium.
Application: A high-net-worth investor with a low marginal utility of risk may still want to achieve a certain return. This portfolio’s downside risk can be reduced by lowering the exposure to beta while increasing the exposure to the value premium. The trade-off is a lower probability of producing above-expected returns.
Application: An individual whose labor capital has a low correlation to the value premium should consider increasing exposure to value stocks. Typical examples are tenured professors, doctors and retirees. Another good candidate for this strategy is a high-net-worth investor whose labor capital is a low percentage of his overall net worth.
Reasons to decrease value exposure (or maintain a “market” exposure)
Reduced risk: Those taking the traditional finance point of view believe in tilting toward growth stocks to reduce portfolio risk. Investors who are exposed to value risk factors in ways other than their investments should use this strategy. This includes owners of distressed businesses, employees and top-level managers of value companies, as well as retirees who receive (or in the future will receive) pension benefits from a value company. For this type of investor, a neutral exposure to value or even a growth tilt (compared to the market) is more appropriate.
Tracking error: Portfolios tilted toward value will not move in lockstep with the overall market. Investors with value-tilted portfolios must be able to stomach the tracking error that occurs during the inevitable periods of value underperformance. Depending on the investor, a more neutral exposure to value might make sense.
Application: An owner or employee of a value company should probably not tilt as heavily toward value stocks as a tenured professor. Other individuals who should consider not tilting to value stocks (or limiting their tilt) are construction workers, automobile workers or any employee or owner of a highly cyclical business. For these investors, a neutral exposure to value, or even a growth tilt (compared to the market), might be more appropriate.
The next step in our asset allocation process will be deciding how much to allocate to small- and large-cap stocks.