Is Your Portfolio “Small” Enough?

Over the last eighty-five years, the stocks of small, publicly-traded companies have significantly outperformed the stocks of larger, more well-known companies.  There has been much debate over the specific cause of this observation, and more importantly,  why it might persist in the future.  However, one seemingly obvious suggestion is that small companies are riskier than large companies, and therefore, investors should be rewarded with a higher expected return for assuming a higher level of risk, or price volatility.

Without delving into the sources of this additional risk, let’s take a look at how small cap stocks have performed over long periods of time.  In this table,  “Small” is defined as those U.S. companies with a market cap that is  less than the median NYSE market equity (AMEX and NASDAQ stocks have also been included).  “Value” is defined as the top thirty percent of stocks ranked by book-to-market ratio.

    The table clearly shows that not only have small companies outperformed large companies, but that “Value” companies have outperformed “Growth” companies.*  This discovery formed the basis of the famous Three Factor Model created by Eugene Fama and Kenneth French in the early 1990s.

When looking at this data it is important to understand  that small cap stocks do not always outperform large cap stocks.  For example, during the technology boom of the 1990s, large company stocks handily outpaced small company stocks.  In addition, small cap stocks generally  get punished more severely  in down markets.  From 2007 to 2009, small cap stocks lost 22.7% per year while large cap stocks lost (only) 18.5% per year.  Similarly, value does not always outperform growth.  Last year, large cap growth stocks beat large cap value stocks by over five percentage points.   However, when the time horizon moves out past ten years, the odds dramatically increase in favor of small over large, and value over growth.

Before making any investment decision, it is critical that you first create a  Wealth Management Plan and an Investment Policy Statement to address your specific goals and objectives.  If your time horizon is long enough, we believe investors will continue to be rewarded (on a risk-adjusted basis) for allocating a portion of their portfolios toward smaller companies with low book-to-market ratios.  VERY IMPORTANT:  This must be done in the context of a broadly diversified portfolio in order to reap the benefits without subjecting yourself to unnecessary risk.

* This table was produced by Dimensional Fund Advisors and shows that the average small cap and value premiums in the U.S. equity market have been positive over the periods indicated.  The return premiums have been volatile, as indicated by the standard deviations, and the annual return differences have sometimes been negative.  The premiums shown are arithmetic averages of the annual premiums.  For example, from July 1946 to June 2011, the returns of value stocks exceeded those of growth stocks by an average of 4.36 percentage points per year.  The return difference had a 13.9 percent annual standard deviation during this period.