These are the downsides of small-cap value stocks
Reprinted courtesy of MarketWatch.com
Published: July 30, 2018
To read the original article click here
After a long, profitable run, the stock markets fell in 2018, then headed upward early this year before retreating to current levels.
What’s an investor to do? When should you head for the exits?
When should you hold tight?
Of course there is no way to know these things until after the fact.
Investing in equities is all about accepting and managing risk.
It might seem like a daunting task, but it’s actually quite possible if you’re willing to examine some investment returns from the past, then examine your own psyche — and see how they fit together.
This is our topic today.
It’s well known that, in broad terms, risk and reward go together.
If you want high returns, you have to take significant risks. And if on the other hand you want to seriously minimize your level of risk, you’ll need to settle for lower long-term returns.
There are many ways to tweak your risks, but the most important one by far is to adjust the balance of your portfolio between stocks and bonds.
For most investors, the ideal portfolio is likely to include both equities (for growth) and fixed-income funds (for income and portfolio stability).
To illustrate the trade-offs, I’ll make some comparisons using only the S&P 500 SPX, 0.06% to represent stocks and only intermediate-term Treasury bonds to represent fixed-income investments.
This simple combination is not what I recommend for most investors, but it’s a good way to illustrate how risks and rewards work together.
The following comparisons of returns and risk factors are based on market data for 49 calendar years, 1970 through 2018.
Here’s the basic question: How much of your portfolio should you hold in equity funds and how much in fixed-income funds? (When I refer to funds, I mean to include mutual funds and exchange-traded funds or ETFs.)
Let’s compare returns and a few risk factors from 1970 through 2018.
In table 1, You’ll see the results over this period for three quite different allocations: 20% equities for the very conservative investor, 50% equities for the moderate investor, and 100% equities for the aggressive investor.* In each case the remainder of the portfolio is in intermediate-term Treasury bonds.
Table 1: Three choices of bonds vs. equities
| PERCENT IN S&P 500 | COMPOUND RETURN | STANDARD DEVIATION | WORST IN 12 MONTHS | WORST DRAWDOWN |
| 20% | 7.7% | 4.6% | -8.6% | -8.9% |
| 50% | 8.8% | 8.0% | -23.2% | -25.9% |
| 100% | 10.2% | 15.1% | -43.4% | -50.9% |
These three variations make it obvious that higher returns — and higher risks — go along with higher proportions of equities in a portfolio.
I have long believed that a moderate allocation of 50% in equities may be suitable for many — perhaps even most — investors, including those who are retired. This is the approach I take with my own investments.
But younger people can afford to take more risk, and they should do so while they are accumulating assets. Likewise, some investors are quite uncomfortable with equities; for some, a 20% to 30% equities stake is all they want to take on.
Fortunately, there are lots of choices. You’ll find other combinations, in 10% increments of equity exposure, in the full table.
Large institutional investors such as insurance companies and pension funds traditionally adopt an allocation of 60% equities and 40% fixed-income funds. These large investment pools need growth to stay ahead of inflation, yet they also need ample protection from catastrophic losses so they can meet their obligations to retirees.
In table 2 below, I show the results of such a 60/40 portfolio with the same parameters as those in table 1 above.
Table 2: 60% equity, 40% fixed income
| PERCENT IN S&P 500 | COMPOUND RETURN | STANDARD DEVIATION | WORST 12 MONTHS | WORST DRAWDOWN |
| 60% | 9.1% | 9.3% | -27.6% | -31.7% |
When you compare these numbers with those of the 50/50 portfolio in table 1, they bear out one of my consistent observations over the years: Every 10 percentage point increase in equities, over the long term, results in an additional 0.2% to 0.5% increase in return.
That might not seem like much of a difference, but an initial $10,000 investment at 9.1% (table 2) will grow in 40 years to $325,829. At a rate of 8.8% (the 50% equity portfolio in table 1), that $10,000 will grow to “only” $291,847.
The difference is significant, and when it is applied to more dollars and more years, it can be life-changing.
Still, we cannot know what the future holds. All we can know is the past.
There are so many ways to slice and dice the returns and risks of the past that you can cherry-pick whatever numbers will support the conclusion you’re looking for.
Many brokers and advisers engage in a variation of this by focusing just on the good times:
• See how much money this strategy can make!
• See how great this fund is!
By contrast, when I present past investment results I like to dig a bit deeper. For example, I always look for the rocky spots, the bumps in the road. Many times I have issued a guarantee that investors who take my advice will lose money along the way.
In the past, such losses have turned out to be temporary, at least for investors who stayed in the game. But not everybody can stay in the game when losses are severe or prolonged.
That’s why I make a point to highlight the worst returns in periods ranging from three months to 60 months. I also calculate and report the worst drawdowns, the declines from high points to lows before recovery begins.
This can give investors a sense of what they may have to withstand in order to earn the expected long-term rates of return.
Accordingly, tables 1 and 2 contain figures for the worst 12 months and the worst drawdowns.
In the full table, I have these and other data points for various combinations of stocks and bonds.
Briefly, here are three other points to note from these 49-year results.
1. I think the 10.2% return of the S&P 500 over this period is reasonable as an expectation for future long-term periods. But I find it hard to believe that fixed-income investments will continue to advance at 6.9%. From 1926 through 1969, government and corporate bonds returned only 2% to 3.3%.
2. With the benefit of knowing how things turned out, it’s very easy to decide that the risks of equity investments were worth taking. But “staying the course” meant sucking it up enough to accept severe bear-market losses in 1973-74 (37.4%), 2000-2002 (-37.8%) and again in 2008 (-37.1%). And this doesn’t even mention a sickening one-day loss of 22.5% in October 1987.
3. There’s no evidence at all that anybody can predict the timing or severity of such losses. However, the evidence is clear that fixed-income investments mitigate those losses. If you use bond funds to provide an extra measure of fixed-income, you should expect lower long-term returns. But if smaller interim losses keep you in the game, the reduced return can be a price that’s very worthwhile to pay.
There’s much more to say about all this, and I encourage you to check out my podcast “What every investor should learn from the Fine Tuning Table.”
NOTE: Figures cited here for the S&P 500 index are for the index itself, which is not directly available to investors. In the full table, returns in all the portfolio columns, including that for 100% invested in the S&P 500, are reduced by 0.1% to reflect possible expenses of owning the assets through index funds or ETFs.
Richard Buck contributed to this article.
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