Turbo-charge your retirement portfolio
Reprinted courtesy of MarketWatch.com
Published: Jan. 16, 2013
To read the original article click here
One of the easiest ways to boost your retirement portfolio is to include funds that specialize in small-cap stocks. Even a modest stake in small-cap funds can beef up your returns without adding much risk.
I’ve been recommending small-cap funds for decades, and you’ll find them in every equity portfolio that I suggest. Let me tell you why you should own some.
When you invest money in stock funds, you want that money to grow over time. And historically, smaller companies have more potential to do just that.
Fifteen years ago, for example, Google was a small niche company that few people took seriously. Now it’s a giant that nobody in business can afford to ignore.
Over the long haul, small-cap stocks have outperformed larger ones. And over long periods of time, mixing equal amounts of U.S. large-cap stocks and U.S. small-cap stocks has significantly boosted return with relatively little additional risk.
In my book “Live It Up Without Outliving Your Money,” I cited an 82-year study showing that small-cap stocks beat the Standard & Poor’s 500 Index SPX, 0.18% in 78% of all 20-year periods. The average difference in return was 2.7 percentage points.
Over the past half century, U.S. small-cap stocks returned 12.4% a year, compared with 9.8% for the S&P 500 Index. You’ll find similar data with international stock funds (which I also recommend for retirement portfolios). We don’t have reliable data going back quite 50 years, but over the past 30 years, international small-cap stocks have compounded at 11.5%, compared with about 9% for large-cap international stocks. (These figures are from indexes, not from individual stocks.)
It’s not hard to understand the reasons behind these differences. It’s a matter of growth potential. (Who is likely to grow more over the next year – a 13-year-old boy or a 27-year-old man?)
So here’s an interesting question: If small-cap stocks are so fabulous, why not plunge head-over-heels into them almost exclusively? The answer involves only one word: time.
Sometimes it takes a long time to get long-term returns. Very few investors have 82 years, or even 50, before they need to see results. The stock market is driven by many factors other than strict long-term logic, and over periods of several years or more, large-cap and small-cap stocks can go sharply in and out of favor. Rarely have both groups been extremely productive — or extremely unproductive — at the same time.
According to another long-term study I cited in my book, the premium return from owning small-cap stocks was considerably more likely to occur over longer periods than shorter ones.
In that study, investors obtained the small-cap premium in only 53% of the 12-month periods; but the reliability of this effect increased to nearly 64% in 10-year periods and to 89% in 25-year periods.
What does this mean to retirees? Statistically, at least one member of a typical couple entering retirement at age 65 can expect to live for 20 to 30 more years. During that time, they will need at least some stock funds in their portfolio to help them keep up with inflation.
If you share my belief that the long-term premium of small-cap stocks will continue, and if you expect to have money invested in stocks for the next 25 years, then you can very easily give yourself a nearly 90% probability of higher long-term returns by including small-cap funds in your portfolio.
You don’t have to wait 25 years, of course, to see the benefits. Over the past 10 years, a portfolio of large-cap stocks, equally divided between U.S. and international, grew at a rate of 7.8%. But if half the portfolio had been shifted into small-cap stocks, equally split between U.S. and international, the return rose to 9.8%. Over 10 years on an investment of $100,000, that’s the difference between $211,927 (just large) and $254,696 (half large, half small).
I’m a firm believer in index funds, and Vanguard’s Small-Cap Index Fund NAESX, +1.31% is a fine choice. According to performance figures through last Friday at Morningstar.com, this fund beat the total return of the S&P 500 Index in every reported period longer than one week, including the year to date, one month, one year and up to 15 years.
The longest period for comparison of Vanguard’s international small-cap fund, three years, shows that it outperformed the EAFE large-cap international stock index in that period by a little more than two percentage points annually.
I rest my case.
Richard Buck contributed to this report.
Purchase on Amazon
Sound Investing Podcast