Value Investing And Tolerating Pain

So you want to be a value investor, like the great Warren Buffett. A worthy goal, to be sure. But before going down that road you may want to ask yourself the following question:

What is my tolerance for pain?

You read that word correctly: pain. To be a great value investor, or any investor for that matter, you need to be able to tolerate a high degree of pain.

What kind of pain? Emotional, psychological and at times physical pain stemming from loss, regret, and humiliation.

Why would a value investor need to endure such things? Let’s take a look…

Large cap value stocks have been underperforming since August 2006.

Nearly 12 years of underperformance is a long time, and extremely painful for any value investor that has stuck to their discipline.

How many of us would actually sit there for 12 years and take that pain?

Not too many. In a State Street survey of over 400 institutional investors, only 1% said they would stick with an underperforming “smart beta” strategy for 3 years before seeking a replacement.

Source: State Street Global Advisors

When a smart beta factor like value is out of favor, it is quickly deemed to have lost its intelligence. There is almost no tolerance for extended periods of underperformance.

But therein lies the problem, for 3-year underperformance is far from atypical for any smart beta strategy. To the contrary, large cap value has actually underperformed large caps in 51% of rolling 3-year periods going back to 1981.

Data Source: FRED data going back to December 1978. Note: in this post Large Cap Value = Russell 1000 Value Total Return Index, Large Cap Growth = Russell 1000 Growth Total Return Index, and Large Caps = Russell 1000 Total Return Index.

What about 5 years? The results are not much better, with large value outperforming in 51% of rolling 5-year periods going back to 1983.