What Is Value Investing, and Does It Still Work?

The original idea is Benjamin Graham's: buy a dollar of assets for sixty cents and let the gap close. The modern version is statistical rather than company by company. A value index sorts the market on a valuation ratio and overweights the cheap half. Nobody at a value index fund is reading annual reports.

Two competing explanations exist for why cheap stocks have historically returned more, and they lead to different conclusions. The risk explanation says value stocks are genuinely riskier, often more leveraged and more cyclical, and the extra return is compensation you earn for bearing that risk. The behavioral explanation says investors overextrapolate recent growth and systematically overpay for it, and the premium is a persistent mistake. If the risk story is right, the premium should persist but you are paying for it in real risk. If the behavioral story is right, the premium can be arbitraged away once enough money chases it, which is roughly what critics argue happened after the early 2000s.

The record is uncomfortable for true believers. From roughly 2007 through 2020, growth beat value by a wide and sustained margin in US large caps, a stretch long enough to end careers and close funds. Investors who held a value tilt through that period underperformed a plain total market index for well over a decade. Any honest presentation of value investing has to lead with that, not bury it.

Then 2022 happened. Rising rates hit long duration growth equities hardest, and the spread between Russell 1000 Value and Russell 1000 Growth was about 21 percentage points in a single calendar year. That single year recovered a meaningful slice of the prior underperformance for tilted investors. It also illustrated the real mechanism: value and growth are, among other things, a bet on the direction of discount rates.

A subtler point that matters more than the debate itself. The gap between what a value strategy returns and what value investors return is large, because tracking error is only tolerable until it is not. An investor who tilts to value, underperforms for eight years, capitulates, and switches to a growth heavy index right before the reversal has captured the worst of both. The premium, whatever its true size, is only available to someone who will actually hold through a decade of being wrong.

There is also a specific tax dimension that rarely gets discussed. Value stocks pay higher dividends on average than growth stocks. In a taxable brokerage account, that means a value tilt generates more current taxable income, which for a retiree managing IRMAA brackets, Social Security taxation thresholds, or ACA subsidy cliffs is not a neutral fact. The same tilt can be clearly better inside an IRA and clearly worse in a taxable account for the same household.

A modest value tilt is defensible. A concentrated bet on value is not. If you tilt, size it so that a decade of underperformance would be annoying rather than plan threatening, and write down in advance that you will not abandon it.

The most important decision is not value versus growth. It is total equity exposure, cost, and whether you will hold through drawdowns. A cheap total market index fund held with discipline beats a clever factor tilt abandoned at the bottom, every time.

If you are drawing from the portfolio, the diversification argument for value is stronger than the return argument. Value and growth underperform in different environments, and owning both means you always have something reasonable to sell to fund a withdrawal.

Where you hold a value tilt matters as much as whether you hold one. The higher dividend yield belongs in a tax deferred or Roth account for most high income households, not in the taxable brokerage account where it adds to modified adjusted gross income every year.

Be skeptical of anyone who presents the value premium as settled in either direction. The people who study this for a living disagree. Anyone selling you certainty is selling you something.

• Adopting a value tilt after value has just outperformed, and abandoning it after it has just underperformed, which is a systematic way to buy high and sell low.
• Confusing a value index fund with Graham style security analysis. They are entirely different activities that share a name.
• Treating the value premium as a guaranteed long run outcome rather than a historically observed and actively contested pattern.
• Concentrating heavily enough in value that a decade of underperformance would derail a withdrawal plan.
• Placing a high dividend value tilt in a taxable account without checking the effect on IRMAA thresholds, Social Security taxation, or ACA subsidies.
• Assuming a value fund is defensive. Value stocks are often more leveraged and more cyclical, and they have their own deep drawdowns, as 2008 and early 2020 both showed.