The value premium is one of the most well-documented facts in finance. To calculate the value premium financial, economists take the return of value stocks (defined as stocks within the top 30 percent of stocks ranked by book-to-market [BtM] value) and subtract the return of growth stocks (defined as stocks within the bottom 30 percent when so ranked). The term HmL—the return of high (H) BtM stocks minus (m) the return of low (L) BtM stocks—is the term used for the value premium. For the 80-year period 1927-2006, HmL was 5.0 percent on an annual average basis. The annualized (compound) HmL was 4.3 percent.

With this knowledge, many investors deviated from pure market-cap-weighted portfolios. Instead, they seek to capture the value premium by "tilting" their portfolios to value stocks. Investors who did so were rewarded with large premiums from 2000 through 2006. The premiums were 37.8, 14.5, 12.2, 3.0, 8.3, 8.3 and 12.7 percent, respectively. This produced an annualized premium of 13.4 percent. However, in 2007, the value premium turned sharply negative.

Tracking Error Risk

After years like 2007, when portfolios experience negative tracking error (when a portfolio underperforms a broad market index like the S&P 500 Index), many investors question their strategy of tilting to value stocks. Very few investors ever question their strategy when it generates positive tracking error. However, investors who tilt their portfolio to value stocks because they are trying to capture the value premium must accept the fact that there will be periods of underperformance. If they are not prepared for that, they should not tilt their portfolio in the first place.

Investors who are questioning their strategy should ask themselves the following question: What has changed that would cause me to abandon my strategy? Those asking the question should consider that the most basic tenet of investment theory is that risk and expected returns are related. Value stocks have provided historically higher returns than growth stocks and stocks have provided higher returns than Treasury bills for the same reason—they are riskier. Because there is incremental risk, investors require a risk premium (higher expected return) as compensation.

The Nature Of Risk

What is important to understand is that if value stocks always provided higher returns than growth stocks, there would not be any incremental risk. Thus, while investors should always expect that in any given year (or quarter or even month), value stocks will outperform growth stocks (because they are always riskier); the "price" of the higher expected return is that the investor must accept the risk that there will be periods when value stocks will actually produce lower returns. The logic is simple. If value stocks always outperformed growth stocks, there would be no risk, and hence no risk premium. The same is true of stocks relative to Treasury bills. The reason stocks have outperformed Treasury bills is that they are riskier and investors demand compensation. That compensation is called the equity risk premium. If stocks always outperformed Treasury bills, investing in stocks would entail no risk and there would be no risk premium.

Thus, the answer to the question, "What has changed?" is "Nothing." You decided to tilt to value stocks because being risky stocks, they offered a risk premium (higher expected returns), and you were willing to accept that risk. Does the fact that they provided lower returns in 2007 than growth stocks mean that they now have lower expected returns than growth stocks? For that to be true you must believe that value stocks are actually safer than growth stocks, or risk and expected return would be unrelated.

Since the obvious answer is that nothing has changed, you should not change your strategy. Instead, you should take advantage of the opportunity to buy value stocks when they are on sale. You would do this by rebalancing your portfolio, restoring your asset allocation to the targeted level.

Bear Markets Provide Important Reminder

While painful to endure, bear markets (or simply, periods of underperformance) are actually a good thing in one important sense. The reason is that if there were no bear markets and stocks were not volatile, risky investments, they would not provide a risk premium. (And the same is true of value stocks.) Periods like 1929-32, 1973-74 and 2000-02, when the S&P 500 Index lost 23, 21 and 15 percent per annum, respectively, are why equities have produced an annual risk premium of about 8 percent over one-month Treasury bills. But the standard deviation of that risk premium has been about 20 percent.

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