Is the Small Cap Premium a Myth?

[Jeff W]

http://www.investorsinsight.com/otb.aspx

[Dazarath]

This is something I was wondering as well. If small/mid caps do outperform large caps in the long run, then that would imply that S&P 500 < Wilshire 5000 < Wilshire 4500, no? In this case, I would prefer to be putting my money in Wilshire 4500 index funds rather than Wilshire 5000, even with the extra variance inherent in small caps.

[Sniper]

That's why you diversify... the different types of stocks whether it be small vs large or value vs growth, or foreign vs domestic, etc... each outperform at various times relative to the other... so unless you want to start guessing which is going to have the outperformance, or actually spending the time to make informed decisions... it is best to simply diversify across, so that you capture a piece of everything [img]/images/graemlins/smile.gif[/img]

[Pokeraddict]

Call me a fool but I have a majority of my Roth in a Russell 2000 fund and it has done very well. It went sideways to slightly up during corrections and performs almost as well as the large caps in run ups. It's about 80% of my Roth (QQQQ is the other 20%).

[Sniper]

[ QUOTE ]
Call me a fool but I have a majority of my Roth in a Russell 2000 fund and it has done very well. It went sideways to slightly up during corrections and performs almost as well as the large caps in run ups. It's about 80% of my Roth (QQQQ is the other 20%).

[/ QUOTE ]

PA, I'd never call you a fool... [img]/images/graemlins/wink.gif[/img]

As long as you know/understand what you are doing, and it fits in your personal risk profile... then you're fine.

[Jeff W]

[ QUOTE ]
QQQQ is the other 20%.

[/ QUOTE ]

I think QQQQ is a fundamentally bad holding. It's an extremely growth-oriented large cap index--LCG on this chart:

<font class="small">Code:</font><hr /><pre>1972-2006

Correlations, CAGR, Volatility

Correlation to:.US Market...500 Index...EAFE/EM....CAGR...StDev
================================================== =============
US Market.........1.0000......0.9908.....0.5944...11. 24...17.46
500 Idx...........0.9908......1.0000.....0.5899...11.3 2...17.22
LCV...............0.9163......0.9054.....0.5535... 13.46...17.24
LCG...............0.9571......0.9680.....0.5309... 10.00...20.22
MCB...............0.9019......0.8618.....0.4946... 13.72...18.44
SCB...............0.8194......0.7460.....0.4595... 13.23...21.66
SCV...............0.7101......0.6410.....0.3585... 15.00...19.96
SCG...............0.8328......0.7663.....0.4751... 10.43...23.75
MicroCap..........0.6894......0.6043.....0.3756... 13.64...26.70
REIT..............0.5284......0.4638.....0.3041... 13.88...16.67
EAFE/EM...........0.5944......0.5899.....1.0000...12.07 ...22.08
LT Treas..........0.2584......0.2806.....0.0935....8. 47...11.37
IT Treas..........0.1878......0.2124....-0.0373....8.13....6.90
ST Treas..........0.1628......0.1845....-0.0920....7.12....4.06
T-Bills...........0.0323......0.0497....-0.1239....5.98....3.00
IT Bonds..........0.2724......0.2930....-0.0190....8.06....5.61
S-TIPS............0.1283......0.0942.....0.3974....7 .64....6.82
Commodities......-0.2466.....-0.2437....-0.1447....8.00...24.53
================================================== ============= </pre><hr />

CAGR=Compound Annual Growth Rate

After Commodities(which are only useful in small dose as a diversifier due to their negative correlation with equities) and Small Cap Growth(SCG), LCG has the worst risk/return ratio. Additionally, it has a high correlation to the total stock market, so it has no diversification benefit! If you go farther back to 1927 the trend holds.

[Dazarath]

[ QUOTE ]
That's why you diversify... the different types of stocks whether it be small vs large or value vs growth, or foreign vs domestic, etc... each outperform at various times relative to the other... so unless you want to start guessing which is going to have the outperformance, or actually spending the time to make informed decisions... it is best to simply diversify across, so that you capture a piece of everything [img]/images/graemlins/smile.gif[/img]

[/ QUOTE ]

Sniper, bonds have outperformed stocks at certain times, but that doesn't imply that they outperform stocks in the long run. If my risk tolerance can handle small caps, and they outperform large caps in the long run, then wouldn't it make sense for me to invest in a small cap index fund?

[mwgr5]

If this is the case you should invest in a small cap fund. Specifically a small cap value fund.

The main question is what percent of your US portfolio should you allocation to small cap value. This is primarily a function of your risk tolerance. It is also important to note that many people think they have higher risk tolerances than they actually do. One of the biggest mistakes you could make is having a portfolio that is too risky for you and selling out of positions during a bad down turn.

So why not invest all of your domestic holdings in Small Cap Value?
The small cap value premium is based on historical information. Know one knows what will happen in the future. While their is a high probability that small cap value will outperform over the long run, their is not absolute certainty.

Thus, the best idea is do diversify. Simply holding a total stock market index and a small cap value index is a very good idea.

[Sniper]

[ QUOTE ]
[ QUOTE ]
That's why you diversify... the different types of stocks whether it be small vs large or value vs growth, or foreign vs domestic, etc... each outperform at various times relative to the other... so unless you want to start guessing which is going to have the outperformance, or actually spending the time to make informed decisions... it is best to simply diversify across, so that you capture a piece of everything [img]/images/graemlins/smile.gif[/img]

[/ QUOTE ]

Sniper, bonds have outperformed stocks at certain times, but that doesn't imply that they outperform stocks in the long run. If my risk tolerance can handle small caps, and they outperform large caps in the long run, then wouldn't it make sense for me to invest in a small cap index fund?

[/ QUOTE ]

Daz, see the answer I gave to PA.

Things to consider:
1. Can you handle the drawdowns...
2. Can you handle the fact that past outperformance doesn't necessarily mean future outperformance.

In general, younger investors should answer yes, more often than older investors. Also, posters here who play poker should also be generally more likely to be able to handle the variance of a riskier investment strategy.

One of the most important things, is simply being able to pull a continuous flow of cash from income and put it into investments (almost any investments)... and over the years continually increase your investment knowledge and adjust your risk profile and investment strategies, as you go. The more you can funnel to investments and the earlier in life you start doing this, the better off you will be, later in life.

[NajdorfDefense]

'James dispels what he calls an urban myth that small caps tend to outperform large caps. If you disentangle the size and value effects the difference goes away'

This is silly, the 'size effect' is the whole point of the outperformance, no?

I will vouch that the 'small-cap' effect should really be called the 'micro-cap' effect, as the majority of it resides in the smallest 10% of smallcaps. But as long as you're not an institution, that shouldn't affect you much.