Value Investing vs. Index Funds – Which Will Maximize Wealth?

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There are so many different ways to approach the stock market. Finding the best one for you is key for your mental well-being, and for your long-term wealth. A common comparison point is value investing vs. index funds. In this article we are going to compare the two and determine which presents the best option for you.

Value Investing vs. Index Funds – High Level

Comparing The Strategies

There are a number of differences when considering Value Investing vs. Index Funds:

Goal of Value Investing vs. Index Funds

With both strategies, the ultimate goal is the same – build your wealth long-term. But the way you go about it and the success metrics of the two methods are different. With value investing, you are trying to beat the market by selecting individual stocks. With index fund investing, you’re trying to match the market by holding a diverse portfolio – basically betting on the whole market.

Types of Securities Held

With value investing, as mentioned above, you are holding individual stocks. You are identifying companies that you believe are either undervalued, or have a high upside in the long term (5+ years). Value investors hold anywhere from 5-30 stocks. With a smaller number of stocks, the performance of each stock will have a greater impact on the value of the overall portfolio.

With index fund investing, as the name suggests you hold one or more index funds. These index funds allow you to purchase into a fund that owns all the companies on the index, allowing for easy diversification. Your account value will move with the performance of the market.

Expected Returns

With value investing, ultimately the goal is to beat the market. Your intention is to purchase a bucket of stocks that will outperform the market indices. Now this is really dependant on your own stock-picking skills. There are people who are really good at this (think Warren Buffet), and these are the stories you hear about. That said, it’s also very possible that you underperform the index, or worse, lose money. So your performance is in your own hands.

With index funds, you will only ever do as well as the market – no better or worse. So if the market goes up 10%, your portfolio goes up about 10%. You will only ever get average returns – but you know much better what to expect.

Index fund investing is less risky compared to value investing, but value investing has the potential for better (or worse) returns.

Level of Effort

Both strategies are heavier on the front end, with research being done up front. As for ongoing effort, value investing has a lot more.

With value investing, you have a lot of upfront research before purchasing a stock to determine if it is worth buying. This often includes digging into financial reports, sector performance, etc. You also need to be thoughtful about when you’re purchasing. Often value investors will take advantage of market dips (think 2008) to get a lower purchase price. For ongoing effort, you need to keep an eye on your existing stocks, as well as potential stocks you want to purchase. There can be some regular churn in your account and it’s up to you to keep the right stocks in your portfolio.

With index fund investing, there’s a bit of upfront work to determine a) how you want your portfolio allocated (% in S&P vs. international vs. bonds, etc.) and b) which specific funds you want to purchase. In terms of ongoing work, there is not much. About once a year, you may need to sell/buy funds to rebalance the percentage allocate to each fund. That’s it.

Summary – Value Investing vs. Index Funds

Both value investing and index funds can be a great way to build wealth. That said, value investing is much more involved that index funds. With this involvement comes the potential for greater returns, but it also can result in underperforming the market.

So which is best?

It depends on your desires in life. If stock market investing was all you ever did, you have higher potential for returns with value investing. That said, it will take a lot of learning and effort, and the feedback cycles are long – meaning it takes a long time to know when you make mistakes. Your performance is solely in your hands.

On the other hand, thinking of your life holistically, I believe index funds are a better option. Because I know my money is growing at a decent rate, I don’t spend much time at all managing it. As such, I’m freed up to invest effort into other parts of my life. This allows me to have the time to develop relationships, improve my fitness and health, or invest time into increasing my earning potential. This means I can spend time advancing my career or chase side pursuits such as this blog.

So it’s ultimately up to you if you believe you’re better off getting better returns in the stock market, or building more income earning potential outside the stock market. What’s really important is that you make a decision, and take action.

For more tips on building wealth, see this article: How to Build Wealth

And for more resources on Index Fund Investing, check out these two books:

• The Little Book of Common Sense Investing – John C. Bogle
• The Bogleheads Guide to the Three-Fund Portfolio – Taylor Larimore