The Rest of the Story

To achieve your long-term financial goals, you need to decide carefully on your mix of stocks and bonds.  Why?  Stocks have had greater volatility, but they’ve also outpaced bonds by a wide margin over time.  Looking at all 10-year periods since 1927, I find the US Total Stock Market Index (CRSP 1-10 Index) averaged +10.4% per year, while Bonds (Five-Year Treasury Note Index) returned just +5.3%.  The average of all 10-year periods saw stocks outperform bonds by an average of 5% per year.  Just 10% or 20% more of a portfolio in stocks has made a considerable difference on the long-term growth of an investment portfolio.  More wealth makes it easier to accomplish your goals.

But is that the whole return story?  Most investors mistakenly believe so.  They invest in the stock market through a basic index fund like the Vanguard Total Stock Index, and focus only on minimizing investment expenses.  But more informed investors know that different stocks have had dramatically different returns.  The smallest and most value-oriented stocks in the market, represented by the Dimensional US Small Value Index, have historically outperformed the overall stock market by as much as stocks beat bonds!  Over the same rolling 10-year periods cited above, the Dimensional Small Value Index beat the CRSP US Total Stock Index by an average of 4.8% per year.

Some investors believe that stocks outperforming bonds is a “sure thing,” but look at the outperformance of small value stocks over the market as a dicey proposition.  That’s wrong.  Over all rolling 10-year periods since 1927, stocks beat bonds 81% of the time.  How often did small value stocks outperform the US Stock Market Index? 83% of the time.  Over intermediate and long-term periods, it’s been (slightly) MORE likely that small value stocks outperformed the stock market than stocks outperforming bonds!

Let’s also look at when stocks beat bonds and when small value stocks beat the US Stock Index.  If small value tends to outperform the market at the same time stocks are beating bonds, there’s less of a benefit to diversifying outside of the large company stocks that dominate the US Stock Index.  Instead of adding a dose of smaller value stocks to your portfolio, you can just ratchet up your overall stock exposure and achieve the same higher expected returns.  The graphic below shows the opposite to be true. 

This chart plots every 10-year period since 1927, and looks at the difference in returns between the US Stock Index and Five-Year T-Notes–represented by the dark blue LINE.  When the line is positive, that means stocks have outperformed bonds during that decade; when the blue lie is negative, that was a decade where stocks trailed the return on bonds.  The green BARS measure a different return series: the result of the Dimensional Small Value Index vs. the US Stock Index during the same periods.  When the green bars are positive, the decade saw a positive excess return for small value stocks over the market; when the green bars are negative, that was a decade when small value stocks had a lower return than the US Stock Index.

The first thing we notice is that both lines are rarely negative.  This confirms the data from above–just 19% of decades saw stocks underperform bonds; only 17% of decades saw small value stocks underperform the US Stock Index.  Next, we notice the lines are almost never negative at the same time.  Sometimes stocks are underperforming bonds, and sometimes small value stocks are underperforming the total stock market.  But outside of the Great Depression at the beginning of the chart, the two rarely occur at the same time.  In fact, they tend to ebb and flow at opposite times!  There are several pronounced periods of strong positive and negative stock returns circled in red.  When stocks are soaring, small value tends to struggle.  When stocks are underperforming bonds, small value tends to generate its best relative returns.  There’s an important lesson here for smart investors…

Basic index investing has become overwhelmingly popular in recent years.  But investors deserve the rest of the story.  A complete investment portfolio is one that considers not just the asset allocation between stocks and bonds, but also the allocation between larger growth stocks and smaller value stocks.  Investors have historically earned a significantly higher return for owning stocks instead of bonds, but also for holding the smallest value stocks over the largest growth stocks that dominate basic index funds.  Diversifying across stocks and bonds is a familiar approach for most; very few, on the other hand, know that just as much bang for your buck is possible by diversifying within the stock market.

Investors have benefitted greatly from their large growth stock allocation in recent years.  If history is any guide, it could be time for small cap value stocks to return to favor.  Now appears to be one of the best times in history to diversify outside of the large cap stocks that dominate most index funds and into smaller value stocks.  

If you’d like help evaluating your portfolio and your allocation (if any) to small cap value stocks, don’t hesitate to contact Servo for an investment analysis–you’ll be sure to get the whole story.


Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.