The one asset class every investor needs
Reprinted courtesy of MarketWatch.com
Published: June 25, 2014
To read the original article click here
During a bit of downtime on a cruise in Italy this spring, I had a chance to revisit one of my favorite topics: The astounding long-term benefits of small-cap value investing.
What I found reinforced my conviction, as I wrote last year, that every stock portfolio should include a small-cap value fund. If investors knew the facts, I think they would be less content to accept the returns and the risks of the Standard & Poor’s 500 Index SPX, 0.98% as if that’s all they need.
Today we’ll look at some of the most important facts any long-term investor should know.
One of those facts is that it’s convenient and easy to invest in small-cap value stocks. These are smaller companies out of favor with investors for various reasons.
I absolutely loved our Tauk small-ship tour off Italy’s stunningly beautiful Amalfi Coast, but as people who know me well can confirm, investing is never very far from the surface of my thoughts.
Sure enough, I found myself thinking about the millions of investors who rely heavily on total stock market funds and the S&P 500 index (these are more similar than you might think) for their futures. These investors probably believe they are making great choices. But in fact, the S&P 500 has the lowest long-term returns of any of the equity asset classes that I recommend.
“Long term” is a phrase that’s bandied about pretty casually. What does it mean? There’s no standard definition, but I think most investors would accept 20 years as a long-term period, and it’s a realistic time frame for analysis.
So, digging into the only investment-oriented book I brought with me on my European trip, I looked up returns from every 20-calendar-year period starting with 1934.
That gave me 61 snapshots, each 20 years long, covering eight decades. That’s long enough to draw some conclusions in which I have confidence.
Start with the S&P 500:
- The best 20-year period for that index was 1980 through 1999. Those years produced an annual return of 17.9%.
- The worst 20-year period for the index was 1959 through 1978, when the annual return was only 6.5%.
- The average return of the 61 20-year periods was 11.6%.
That’s not bad, and not even awful over the worst 20-year period.
Now let’s look at the small-cap value index:
- The best 20 calendar years to have invested in small-cap value stocks were 1977 through 1996; the annual return was 24%.
- The worst 20 years for this particular index were 1955 through 1974, when the annual return was 9%.
- The average return of the 61 20-year periods was 16.7% — an improvement of 46% when compared with the S&P 500.
- Here’s one that really surprised me: Of these 61 periods, small-cap value stocks beat the S&P 500 60 times. If that’s not consistency, I don’t know what would qualify.
Those higher numbers look nice, but you can’t appreciate how nice unless you do the math and see how they compound.
Assume you invest $5,000 a year for 40 years and obtain the average results. Would you rather wind up with $3.4 million or $14.4 million? The smaller result, from the S&P 500, is certainly nothing to sneeze at. But the second figure, from small-cap value stocks, is more than a home run — I’d call it a grand slam.
Savvy readers will already be wondering why, if these numbers are true, everybody doesn’t invest in small-cap value stocks.
Almost by definition, value stocks are those that are perceived by investors as riskier than average. Investors, naturally, are risk averse and don’t like to lose money.
So let’s look at risk. The most common way to compare risks is by standard deviation. And sure enough, small-cap value stocks have a higher standard deviation (meaning they are more volatile) than the S&P 500.
According to figures I found (after I was back on the shore from my cruise, mind you) at Morningstar, the recent 15-year standard deviation of the small-cap value index was 21.1. That’s 37% higher volatility than that of the S&P 500.
If that’s all you look at, you could easily conclude that small-cap value stocks are a lot riskier than the index that’s widely used as a benchmark for the U.S. stock market.
But risk comes in more than a single variety. Standard deviation is abstract and statistical. I’ve never heard an investor complain: “Paul, I just can’t take this standard deviation any more!”
In the real world, what actually bothers investors is losing money. And a period of one year seems to be a common way people measure whether they are winning or losing.
Over this 80-year period, the S&P 500 lost money in 20 calendar years. I wondered what happened to small-cap value stocks in those same years. If this asset class were actually more risky than the S&P, here’s where we might find the evidence.
In its 20 losing calendar years, the S&P lost an average of 12.1%. During those same years, the average return of the small-cap value index was a loss of only 9.2%.
How can this be? The riskier asset class is supposed to lose more money, right? That’s what I would have thought too. Then I looked a bit further.
In four of the years in which the S&P 500 lost, small-cap value stocks actually made money.
However, this wasn’t a one-way street. In this long period there were seven calendar years in which small-cap value stocks lost money (an average of 6.6%) and the S&P 500 made money (averaging 7.3%).
Obviously, these asset classes don’t always move up and down together. For investors who own both and can take the long view, that’s good: The combination helps smooth out the annual ups and downs of the portfolio.
As I continued my leisurely Mediterranean cruise, I thought about how real-life investors respond to losing money. And I came up with one other interesting wrinkle.
Whenever the S&P 500 has a losing year, many investors start to lose their confidence. Frequently they will sell equities or stop contributing to their savings. But what might they do if they knew the following?
In the 20 calendar years immediately after the S&P 500 lost money (20 calendar years, in other words), small-cap value stocks on average gained 32.4%.
There’s no guarantee that pattern will continue, of course. But our data covers many decades, and these results show up during all sorts of market conditions, from years that were merely disappointing to some that were downright nasty.
One lesson I take away from this is that small-cap value stocks (throughout this article I have cited asset-class returns compiled by Dimensional Fund Advisors, which has the best small-cap value index I know of) are a valuable tool to help calm the sometimes-angry seas of the S&P 500.
Now I’d like to get back to my photos from that cruise – which was paid for partly by the gains from small-cap value stocks.
Richard Buck contributed to this article.
Purchase on Amazon
Sound Investing Podcast