Opinion: why this fund combination is better than the S&P 500

“I wish I had a dollar for every time I’ve heard Paul Merriman say ‘small cap value’.”

One of my readers posted that recently, perhaps to make fun of my repeated reference to this asset class.

But I make no apologies for being a fan and champion of a class of stocks that have outperformed almost anything else you can invest in in the long run. And as I’ll state below, small cap value can reduce the risks for long-term investors rather than add to it. I will come back to that subject; For now, remember the phrase ‘long term’.

People who put money aside for their retirement do so to allow that money to grow. It’s really quite simple.

If you are planting a tree and you want it to grow very tall in your lifetime, you should plant a species that grows quickly rather than one that grows more slowly. This is also quite simple.

To briefly continue that imperfect metaphor, you might think of the S&P 500 index SPX,
(or the very similar US Total Stock Market Index) as a tree species that will grow three to five feet per year.

Likewise, small-cap value stocks can grow five to seven feet a year.

If you planted those trees together, you would definitely notice the difference after 10 years; after 20 years the difference would be striking.

From 1970 to 2020, the S&P 500 rose at 10.7%. Small-cap stocks rose at 13.5%. In a year or two it wouldn’t matter much. But in a few decades — remember that phrase “long-term” — the difference would be very noticeable.

To know:

Imagine if you could throw $6,000 a year into an IRA for 40 years and retire for another 30 years. If you were to make even an additional 0.5% long-term return, you would probably have $1 million more to spend on retirement and bequeath to your heirs.

Based on the long-term returns I just mentioned (10.7% for the S&P 500 and 13.5% for small cap value), the small cap value could give you more than five times that $1 million difference.

The Merriman Financial Education Foundation did a year-over-year comparison of these two asset classes from 1970 to 2020.

this table shows you at a glance which asset class outperformed the others each year – and by how much. In 1984, for example, the S&P 500 outperformed small-cap value by 4.3 percentage points. In 2006 — and again in 2012 — the small cap outperformed 5.8 percentage points.

The table also makes clear why people who either don’t have a long-term perspective or don’t understand that diversification are currently shunning small-cap value: In each calendar year 2017 through 2020, the S&P 500 outperformed. Small-cap value stocks didn’t lose money in those years; they just made less.

Fortunately, the choice between the S&P 500 and small cap value is not an all-or-nothing decision.

This table has columns of returns showing year-over-year results for combinations of the S&P 500 and small cap value in 10 percentage point increments.

For example, if you wanted the majority of your investments in the S&P 500, but with a boost to get you twice that extra 0.5% long-term return, you could have achieved that with a combination of 70% in the S&P 500 and 30 % in small cap value. That blend had a compound yield of 11.7%.

Now let’s return to the subject of risk. To statisticians, risk can look like a standard deviation. But for investors, risk is about losing money.

Here are two very valid questions: How much would you have lost in the worst 12 months if you were 100% in the S&P 500? And how much if you were in the 70/30 combination I just described?

Neither answer is pretty. The S&P 500’s worst 12 months was a 43.3% loss; for the 70/30 combination the loss was 45.1%.

Obviously, that made the 70/30 combo more mathematically risky.

But I doubt that many investors willing to tolerate a 43.3% loss (the S&P 500) would suddenly bounce back after another 1.8 percentage point loss of small cap value stocks.

The table also includes these tidbits: Out of these 51 calendar years, the S&P 500 outperformed in 24 years, by 11 percentage points on average. Small cap value, on the other hand, outperformed in 27 calendar years, by an average of 16.8 percentage points.

Small-cap value investors shouldn’t expect their returns to be comparable to the S&P 500. Over the past 51 years, the calendar-year returns of these two asset classes have been within 5 percentage points of each other just eight times. In nine years, the difference was more than 25 percentage points.

Personally, I’m always curious how many calendar years produce a loss. Over this period, the S&P 500 lost money in 10 years (average loss = 14.1%); small cap value lost money in 12 years (average loss = 14.5%).

But here’s something that I think is far more important, something that should get the attention of any long-term investor:

An extremely risky period for stock investors in recent memory was 2000-2002, which came right after a five-year bull market in which the S&P 500 posted a 28.6% compound return.

Investors, of course, thought it would stay that way.

But in 2000, the index lost 9.1%. Then it lost another 11.9% in 2001. As if to wake up investors who hadn’t noticed, the S&P 500 lost another 22.1% in 2002.

In those same three years, small cap value won 21.3%. This sort of thing is how investors benefit from diversification.

While the future won’t repeat the past, the experts are pretty much in agreement that higher returns are correlated with higher risks in the long run.

If you’re putting money aside for a month, a year, or even just a few years, you should be more concerned with risk than potential rewards.

But if you’re saving for retirement, you should aim for higher returns in the long run, as long as you can tolerate the associated short-term risks.

For more information on this topic of the S&P 500 and small cap value, I have recorded a podcast.

I’m also scheduled to deliver a presentation, “Twenty Things You Should Know About Small Cap Value,” at the upcoming two-day virtual American Association of Individual Investors Conference.

Richard Buck contributed to this article.

Paul Merriman and Richard Buck are the authors of: We’re talking millions! 12 Easy Ways to Boost Your Retirement.