The hot tip. Who doesn’t appreciate a little “inside information” when it can be used to our advantage?
“Pssst”, says the guy at the horse track, “I’ve got it on good authority that Dander Ruff in the 5th is gimpy today and Getty Up is a lock to win the race”.
“I’ve checked with my sources”, declares the guy on ESPN, “contrary to official reports, their quarterback has not recovered from last week’s concussion and will not play in the game tomorrow”.
“She loves yellow roses” says your office mate, “I heard her tell Jane in accounting just yesterday”.
“U.S. small company stocks have outperformed U.S. large company stocks an average of 5.65% per year since 1927”, reports your advisor, “and international small company stocks have outperformed the Europe, Australasian and Far East (EAFE) benchmark index by 4.30% per year since 1975”.
OK, I admit playing the ponies, rooting for your favorite team or winning in love may be a bit more exciting than constructing the ideal portfolio. The good news is your chances of success are much greater relying on 90 years of academic evidence than some guy at the track, on TV or the cubicle next to you.
As previously discussed, the research and market analysis of Professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College identify three factors that account for 96% of the performance of a diversified investment portfolio. Their work shows differences in portfolio returns are directly attributable to the relative size of the companies owned as measured by market capitalization, the value vs. growth characteristics of the stocks owned and the percentage of stocks vs. bonds in a portfolio.
Last week we looked at the value premium available to investors who invest in value stocks as opposed to growth stocks within a diversified portfolio.
This week we will explore the enhanced returns, or small stock premium, available to investors who favor small company stocks over large company stocks within their diversified portfolio.
Deciding what is a small stock as opposed to a large stock is a relative process based on comparing the market capitalization (the current price of a stock times the number of shares issued by the company) of public companies. Market capitalization can then be ranked from highest to lowest. The top 50% is considered a large capitalization company. The bottom 50% is considered a small capitalization company.
The small capitalization (or small cap) premium is defined as the difference between the average returns of small cap and large cap stocks. The average annual U.S. small cap premium, or incremental percentage benefit, to an investor who owns U.S. small cap stocks instead of U.S. large cap stocks on the New York Stock Exchange was a whopping 5.65% per year from July 1927 to June 2007.
As noted above, the size premium is also available internationally as small cap international stocks outperformed their international EAFE index by an annual average of 4.30%. And one of the great benefits of investing in small cap international stocks is the evidence they are less correlated to the U.S. Market, meaning your portfolio should be more balanced and achieve greater long-term returns than a less diversified portfolio.
It is important to note investing in small cap stocks is not a free lunch. Risk and reward are always related. Small cap stocks, both in the U.S. and internationally, have higher short-term volatility. There will be periods of time when large cap stocks (just as we discussed last week with value vs. growth stocks) outperform small cap stocks. An analysis of five-year moving averages for U.S. small cap premiums shows small caps outperform large cap 64% of the time, meaning there are periods of underperformance in the pursuit of long-term gains.
Investors are often tempted, if not encouraged, to implement timing or switching strategies to bounce between small and large cap stocks depending on which asset class is in favor. Intuitively this makes sense. Why sit in an underperforming category when greater returns are available elsewhere. As is often the case, the academic research contradicts conventional wisdom.
Forecasts are notoriously inaccurate. Trading costs and tax implications are an impediment to enhanced returns. Time spent analyzing market moves and digesting economic news can feel like a frustrating waste when you guess wrong.
Most importantly, a buy and hold strategy historically outperforms a switching strategy over the long-run. For example, an investor who tried to time the market from July 1946 to June 2007 by switching out of small stocks and into large stocks after time period runs when small cap outperformed large cap stocks (runs of three years, four years or five years) would consistently underperform the patient investor who remained in small cap stocks the entire time by 0.66% to 2.25% annually. How’s that for reaping rewards while avoiding stress!
The academics like to say “a multifactor approach incorporates both size and value measures – and exposure to non-U.S. markets – in an effort to increase expected returns and reduce portfolio volatility”.
As for you and me, we can simply rely on the academic evidence that small cap stocks are fundamental to our successful pursuit of Peaceful Wealth.
R. Scott Maxwell is a Vice President and Wealth Management Coach at Talis Advisors, a wealth management firm headquartered in Plano, Texas. He is committed to teaching investors the truth about the stock market. Scott and the team of professionals at Talis Advisors manage beautifully diversified, low cost portfolios for clients throughout the United States, offering independent investment advice based on Nobel Prize winning research with a focus on maximizing returns, maximizing value and maximizing safety to meet client objectives. Scott can be reached at 972-378-1794 or 866-608-2547 or by email at smaxwell@talisadvisors.com. You can also contact him via their less than subtle web site FireYourBroker.net.
