The death of the value premium is premature

(MoneyWatch) One of the most common mistakes made by investors is what can be called recency -- the tendency to give too much weight to recent experience and ignore long-term historical evidence. This is a mistake many investors are making right now with value stocks.

For the five years from 2007 through 2011, the value premium (or the difference in returns between value stocks and growth stocks) was negative each year except 2008, and the average annual value premium was -4.0 percent. The cumulative underperformance for the period was -19 percent. Investors who saw this type of underperformance may have jumped out of value stocks. However, 2012 turned out to be a year when the value premium turned strongly positive -- 6.4 percent.

• What exactly is the value premium?
• When do the risks of value stocks appear?
• Do value stocks outperform growth stocks?

Even with this strong performance, the past three and five calendar year periods still show a negative value premium of -0.8 percent and -0.4 percent, respectively. Even the 10-year premium is just 1.9 percent, or less than one-half the long-term annual premium of 4.7 percent. There are still a lot of investors who may be thinking that the value premium has gone away.

Investors who know their financial history know that this type of what we might call "regime changes" is to be expected. In fact, while the value premium has been quite large and persistent over the long term, it's been highly volatile. For one, the annual standard deviation of the premium has been 12.6 percent, or more than 2.5 times the premium itself. Also, since 1926, the value premium was negative in almost 40 percent of years and in almost 25 percent of five-year periods. Thus, periods of underperformance like we have seen recently shouldn't come as any surprise. In fact, they should be expected, though we don't know when they'll occur. And they certainly shouldn't cause investors to abandon a well-developed plan. Nor should it cause investors to question the existence of the value premium.

In my latest book, "Think, Act, and Invest Like Warren Buffett," I provide 30 rules of prudent investing. One of them is that it's not enough to have a well-developed plan. You must also have the discipline to stay the course, rebalancing and tax-loss harvesting as needed. Unfortunately, even well-developed plans end up in the trash heap because investors lose discipline when their strategy doesn't appear to be working. Thus, the key is to understand the principles behind your strategy so you don't overreact during the times you don't get the outcome you want.

To help you avoid the mistake of recency, keep the following example handy. The risk premium of investing in stocks (or the difference between the returns of stocks and riskless assets) has been almost 8 percent a year. It's also highly volatile, with an annual standard deviation of about 19 percent (also about 2» times the premium itself). However, it's that very volatility that makes the stock risk premium so big. You're compensated for taking that risk by getting large expected returns. Unfortunately, this also means there will be times you won't get that premium. (If you always received higher returns, it simply wouldn't be that risky.)

As proof of that consider that from 1969 through 2008, U.S. large-cap growth stocks returned 7.8 percent and underperformed 20-year Treasury bonds which returned 9.0 percent. That's a 40-year period where investors took all the risks of stocks and underperformed U.S. long-term Treasuries. Should that have convinced investors that the strategy of believing in a stock risk premium was wrong? Of course not. The logic is still the same. Stocks are riskier and must have higher expected returns. It's just that the risk showed up for this very long period. Those who abandoned their plans missed out on the greatest bull market since the 1930s.

What's important to understand is that the premiums for the market overall, small stocks and value stocks have been earned only by those investors disciplined enough to stay the course through the periods when the asset classes they have invested in underperform. And, as we've seen, the periods can be quite long -- long enough to test in the most disciplined of investors. That's perhaps why Warren Buffett has stated that his favorite holding period is forever.