“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 meaning to poke fun at my repeated reference to this asset class.

But I make no apologies for being a fan, and a champion, of a class of stocks that over the long run have outperformed almost anything else you can invest in. And as I will assert below, small-cap value can actually reduce risks for long-term investors instead of adding to it. I’ll return to that topic; for now, remember the phrase “long-term.”

People who set money aside for retirement do so in order to make that money grow. It’s really pretty simple.

If you are planting a tree and want it to become very tall in your lifetime, you should plant a species that grows rapidly rather than one that’s slower. This is also pretty simple.

To continue that imperfect metaphor briefly, you could think of the S&P 500 index
SPX,
-0.57%

(or the very similar U.S. Total Stock Market Index) as a species of tree that will grow three to 5 feet per year.

Likewise, small-cap value stocks might grow five to 7 feet a year.

If you planted those trees near each other, after 10 years you’d certainly notice the difference; after 20 years the difference would be striking.

From 1970 through 2020, the S&P 500 compounded at 10.7%. Small-cap value stocks compounded at 13.5%. Over one or two years, that wouldn’t make a lot of difference. But over a few decades — remember that phrase “long-term” — the difference would be very striking.

To wit:

Imagine you could sock away $6,000 a year in an IRA for 40 years and retire for 30 more years. If you achieved even just an extra 0.5% long-term return, you would likely end up with $1 million more to spend in retirement and leave to your heirs. 

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

The Merriman Financial Education Foundation has produced a year-by-year comparison of these two asset classes from 1970 through 2020.

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

The table also makes it clear why people who either lack a long-term perspective or who don’t understand diversification are shunning small-cap value right now: In every calendar year 2017 through 2020, the S&P 500 has done better. 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 isn’t an all-or-nothing decision.

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

For example, if you wanted most of your investments in the S&P 500 but with a boost to get you twice that 0.5% extra 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 mixture had a compound return of 11.7%.

Now let’s return to the topic of risk. For statisticians, risk might look like 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 worst 12 months of the S&P 500 was a loss of 43.3%; for the 70/30 combination, the loss was 45.1%.

Obviously, that made the 70/30 combo riskier mathematically.

But I doubt that many investors who were willing to tolerate a loss of 43.3% (the S&P 500) would then suddenly bail out after another 1.8 percentage points of loss from small-cap value stocks.   

The table also contains these tidbits of information: Of these 51 calendar years, the S&P 500 did better in 24 years, by an average of 11 percentage points. Small-cap value, on the other hand, did better in 27 calendar years, by an average of 16.8 percentage points.

Small-cap value investors should not expect their returns to be similar to the S&P 500. In the past 51 years, the calendar-year returns of these two asset classes were within 5 percentage points of each other only eight times. In nine years, the difference was more than 25 percentage points.

Personally I’m always curious about how many calendar years result in 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 I think is much more important, something that should get the attention of every long-term investor:

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

Investors naturally thought this would continue.

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

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

Although the future won’t duplicate the past, there is virtually no disagreement from the experts that over the long term, higher returns are correlated with higher risks.

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

But if you are saving for retirement, you should seek higher long-term returns, as long as you can tolerate the short-term risks that go with them.

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

Also, I’m scheduled to make 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 Simple Ways To Supercharge Your Retirement.

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