As we begin the New Year many investors comb the
business news for jewels of wisdom about how to invest for the coming year.
For many, the predictions for 2006 will offer little guidance as the forecasts
are particularly varied. As a practical matter, I’m not sure the predictions
really mean much anyway so it causes one to return to the more basic question,
where do returns come from? To put it another way, where can I get the best
return, on average, over time?
We all know that there is no one sector that will
always be "the place to be" in the investment world. Market leading sectors
change constantly and legions of investors have mistimed getting into and out
of sectors they believed were ripe for a substantial over or under
performance. We also all know that maintaining a diverse investment portfolio
is critical to limiting volatility and being sure that you always have at
least some exposure to market sectors that may do unusually well. But is there
one area that has tended to outperform on average over time? The answer is
yes. A recent review of returns over the last 25 years (1980 – 2004) shows
that Small Cap Value based stocks produced the great average return of the
major domestic stock sectors. Here’s a more complete look at the numbers over
the 25 year period as derived from Morningstar Principia data*
Avg. Return% Std.
Deviation Growth of
$10,000
S&P 500 Index
13.50
16.31
$237,174
U.S. Large Growth
11.50
21.35
$152,010
U.S. Large Value
13.94
14.34
$261,159
U.S. Mid-Cap Growth
12.47
22.84
$188,763
U.S. Mid-Cap Value
15.72
14.95
$384,778
U.S. Small-Cap Growth
10.49
23.09
$121,081
U.S. Small-Cap Value
16.33
16.53
$438,827
It’s pretty clear that the U.S. Small-Cap Value
sector handily outperformed all the other sectors over the last 25 years. The
long term superiority of this sector is also well supported by extensive
research done by Gene Fama at the University of Chicago so it would appear
that this is more than just an interesting anomaly. So why not just load up on
small value and be done? Simple, these returns did not happen in an even,
upward progression. Even though small cap value showed average volatility in
line with the S&P 500, it still saw some years with big losses. Diversity is
still important. Also note that these returns came not due to skillful stock
picking, but by owning the whole sector. In the realm of small companies it’s
especially difficult to pick the winners and losers as most companies have
neither a long track record to examine nor get the attention of any
professional analysts. To properly play this game, you’ll need to own them
all.
The point of this missive is that returns don’t
always come from the places you think they will but for those of us with a
long term investment perspective it is possible to overweight our allocations
in areas of the market that historically have offered better returns. The key
is to maintain the diversity of your holdings and above all be prepared to
hold it for a long time.
Please feel free to call me if you have any
questions about this or any other related topics.
Randy Gridley
January, 2006
