Beating “the market” is not easy. Every year there are any number of studies published which tell us only (pick a number between 10% & 55%) of active managers beat the market in a given year. (Source: Morningstar, The Economist)
If you have the discipline and patience, however, there are three strategies which have been proven to outperform the market over longer periods of time.
- Small company stocks
- Value stocks
- Stocks showing strong price momentum
None of these strategies work all the time but that’s a good thing. If they did the market would quickly arbitrage away any advantage until it disappeared entirely. And because they don’t always work, discipline and patience are needed. It’s easy to be disciplined when your investment strategy is working well. When it isn’t, you find out how patient you really are.
Please note, this post only focuses on investing in U.S. stocks. It does not take into question the much more important discussion of what your overall asset allocation should look like. Your specific asset allocation needs to take into account all aspects of your individual financial situation. Nothing stated here should be construed as investment advice.
Mr. Market is a Tough Competitor
Most investors think about “the market” as the Dow Jones Industrial Average or S&P 500. These indexes are what’s most talked about in the media and so have become the de facto “stock market”. In reality, they only represent the performance of large company stocks, 30 in the Dow and around 500 in the S&P. The rest of the U.S. stock market contains over 3,000 issues and these are usually performing differently than either the Dow or S&P 500.
And there are tens of thousands of very smart, highly educated professional investors studying the stock market every day. Any news about a company is instantly evaluated and reflected in its stock price. Because of this, the market is seen as highly efficient.
When measured over shorter periods of time, the numbers bear this out. Between 1995 and 2014, an average of only 37% of actively managed large cap mutual funds beat the S&P 500 in a given year. (Source: Morningstar, The Economist) If the pros have this much trouble, it’s no wonder that many investors have decided that they have no shot.
What Works on Wall Street
Academic research has found 3 strategies, or factors, that have historically outperformed the S&P 500. The first is that smaller companies (aka small caps) tend to outperform larger companies. The other two are value stocks and price momentum. We’ll spend the rest of this article on small caps. You can find the discussion on value stocks here. Price momentum will be covered in a future post.
Although probably known among professional investors for several decades, formal research on small cap outperformance versus large caps was first published in 1981 (Source: Banz, Journal of Financial Economics). Since then, it has been confirmed multiple times, most notably by Kenneth French and Nobel Prize winner Eugene Fama in their 1993 research paper, “Common Risk Factors in the Returns on Stocks and Bonds.”
Looking at a chart of the past 28 years, we can see this effect in practice. The black line represents the Russell 2000, an index of small companies, and the tan line is the S&P 500.
Bring Your Antacid
With greater return potential, the risks are also typically larger. This is definitely true of small cap stock investing. The greatest risk is smaller companies don’t have the financial stability of larger companies. Many more of them go bankrupt as a result. Even those that survive can see their stock prices drop precipitously during times of financial stress. Look back at the previous chart to see what happened in 2008. At one point, small caps as a whole were down 75% – 80% in a little over a year with much of that drop coming in a 3 month time period. Anyone heavily invested in these stocks during that time would have needed an iron stomach!
Those risks are also the reason why, as a group, they grow faster than large companies. Because they are small, they usually have more growth potential than their larger brethren. A company that has a 5% market share only has to add 5% more to double in size. A company that owns 50% of the market would have to drive out all other competition to achieve that same level of growth.
Patience is Rewarded
So while small cap stocks are more volatile than their large cap counterparts, they reward patient investors who have a long time horizon (i.e. decades) with outperformance. There have been periods of underperformance, but historically they have done better by 3% per year (12.7% vs 9.7%).
Historical Performance by Decade and Overall (Annualized)
For me, percentages are easy to quote but hard to wrap my brain around. I like to look at things in real dollars. So let’s look at an example. Using the historical averages, an investment of $100,000 in small caps over 20 years grows to $1.2 million. The same investment in large caps becomes $700,000.
The rewards are there if you can manage the additional risk.