Value vs. Growth vs. Index Investing

When is the best time to invest in index funds vs. value and growth?

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The growth vs. value funds investing debate is as old as investing itself. Common arguments are which is best, or when the best time or circumstance to invest in each one might be. Some investors argue about how to balance value, growth, and index all in one mutual fund.

As the debate rages, newer investors are left wondering who to listen to as they try to decipher the world of investing. New investors should learn the definitions of each of the categories of funds, learn some strategies to use, find some funds, and conduct an analysis of them.

In this manner, each investor finds funds that match their strategies, risk tolerances, and investing goals. Along the way, they find which categories work for them, which ones don't, and whether any combinations work.

Definitions of the Funds

Value-oriented mutual funds primarily invest in stocks considered to be a relatively better value compared to a given set of criteria. The manager of a value fund establishes the criteria and selects stocks that measure up. Such stocks will be selling at a price that is comparatively low in relation to one of the established criteria. By these criteria the measures may imply a theoretical price higher than the currently traded share price. Earnings data or other fundamental value measures of the stock, such as debt-to-equity or the price/earnings-to-growth (PEG) ratio, are commonly used in value criteria.

Growth stock mutual funds, on the other hand, primarily invest in growth stocks, which are stocks of companies that are expected to grow at a rate faster in relation to the overall stock market.

Index stock funds seek to mimic the price movement of a particular index, which is a sampling of stocks or bonds that represent a particular segment of the overall financial markets. For example, the Standard & Poor’s 500 (S&P 500) is an index consisting of 500 of the largest U.S. companies by market capitalization, such as Facebook, Microsoft, and

Some Strategies and Comparisons

Few analysts would argue that value funds generally perform better, over time, than growth funds in uncertain market conditions and economic environments. Alternatively, when markets are trending higher fueled by consumer confidence and optimism, growth stocks tend to perform better. However, there is no question that followers of both camps—value and growth objective investors—strive to achieve the best total returns.

Much like the divides between political ideologies, both sides want the same results; they simply disagree with the other's methods to achieve them (and they often argue their sides just as passionately as politicians).

Value investors believe the best path to higher returns, among other things, is to find stocks selling at a discount; they want low price-to-earnings (P/E) ratios and higher dividend yields.

Growth investors believe the best path to higher returns, among other things, is to find stocks with strong relative momentum; they want high earnings growth rates with little to no dividends.

A Perspective on Returns

It is important to note that the total return of value stocks includes both the capital gain in stock price and the dividends, whereas growth stock investors typically rely solely on the capital gain (price appreciation) because growth stocks do not often produce dividends.

In different words, value investors enjoy a certain degree of "dependable" appreciation because dividends are fairly reliable, whereas growth investors typically endure more volatility (more pronounced ups and downs) of price.

Furthermore, an investor must note that financial stocks issued by banks and insurance companies represent a larger portion of the average value mutual fund than the average growth mutual fund.

The oversized exposure of value funds can carry more market risk than growth funds during recessions. For example, during the Great Depression, and more recently the Great Recession of 2007 and 2008, financial stocks and funds experienced much larger losses in price than any other sector.

How Index Funds Compare

Index stock funds are normally grouped into the "large blend" category of mutual funds because they consist of a blend of both value and growth stocks. An index investor usually prefers a passive investing approach, which is to say they don't believe the research and analysis required for active investing (neither value nor growth independently) will produce superior returns that are consistently higher than that of the simple, low-cost index fund.

Index investors may also believe that the blend of both value and growth attributes can combine for a greater result—the formula for which might be one-half value plus one-half growth equals greater diversity and reasonable returns for less effort.

Key Takeaways From Historical Performance

These are points worth noting from the historical performance of value funds, growth funds, and index funds. No investment advisor worth listening to recommends market timing—but the best time to invest in growth stocks is typically when times are good during the latter (mature) stages of an economic cycle, during the last several months that typically lead up to a recession, but only if you intend to sell before the downturn.

If you're not purchasing for the short term, you may want to buy your funds long before indications of a recession (or at the bottom of it), ride it out and hope for rewards on the reversal (as Warren Buffett so often teaches).

Growth tends to lose to both value and index when a bear market is in full swing (market trending down, prices falling). Index funds don't often dominate one-year performance but they tend to edge growth and value funds over long periods, such as 10-year time frames and longer.

When index funds win, they typically win by a narrow margin for large-capitalization stocks but by a wide margin in mid-cap and small-cap areas. This is at least partially attributable to the fact that expense ratios are higher (and thus returns are lower) for the actively managed funds represented by growth and value.

This index outperformance for mid-cap and small-cap segments is also significant because many investors believe the opposite—that actively managed funds (not index funds) are best for mid-cap and small-cap stocks but passive investing (indexing) is best for large-cap stocks.

Neither growth nor value investors can claim an outright victory in past performance history. However, index investors can claim they may not often be the top performer but are less often the worst performer during a period. Therefore, they can be confident in receiving at least average returns for a lower average or below-average level of market risk due to diversification and low costs.