“When Small is BIG!”
The market’s been moving around lately (with the usual accompanying commentary), so I’d like to revisit some basics, plus the science. I’m always talking about ‘global diversification’ and proper allocation. But what exactly does that mean and WHY does it matter? This email will be divided into 3 parts, because otherwise, it’ll be too long and you’ll all glaze over.
About a week ago, I was studying last year’s returns across all the asset classes. Do you know what the entire US market returned as a composite? How about 21%?
Take a look at these returns for the four major US indices from mid-Feb to end of December 2016, despite BREXIT, and all the pundit prognostication and election blather.
Did you know ahead of time that 2016 would be a good year? Did you know that a lot of those returns happened after the election? By the way, no one can actually ‘own’ the index. Index ‘funds’ are attempting to mimic the index, which changes. More on this later.
We all want great returns, but they’re never linear! So, what do these returns, negative and positive, equate to in terms of dollars over the last 20 years? Let’s look at just 2 indexes: the S&P (large US growth) and Small Value (Russell 2000). We start out with $100,000 and let’s see what it goes through . . . and grows to.
Well, darn! If I’d only known 20 years ago that Small Cap Val was the ‘best in class’, I’d have put all my money there! SMALL is BIG! Now, no sane person would do that because the roller coaster ride would be too crazy. In this case, however, compare the years 2000, 2001 and 2002. If there was ever a great example of why diversification matters . . . this would be it. No one knows ahead of time what the market will do, and no one can consistently ‘beat’ the market. If you owned both classes, the dip through those years would actually be much less, and you’d have more dollars than what a lot of people ended up with because they were predominantly in the S&P.
What matters most is a long term strategic plan, the ability to capture the entire market (without overlap or over-weighting), the proper allocation for your time horizon and withdrawal rate, and the discipline to stick to the plan, despite the insanity around you. [That’s where I come in. 😉 ]
The Rise of Evidenced-Based Investing. This is NOT ‘just’ index investing. (Excerpted from ThinkAdvisor)
The mutual fund industry is built on a web of deeply entrenched myths of superstar fund managers, benchmarks, quality fund families, quests for value and high-flying recent returns. An iconic television ad right that aired before the internet bubble burst showed Janus fund analysts inspecting underground fiber optic cables to literally dig up value for investors. Fund investors like a good story. (I remember this one.)
In academic finance, the story isn’t nearly as interesting. Common mutual fund narratives can be relegated to the fiction section of the bookshelf. Why do financial scientists have such a different view of investing than many in the financial services industry?
Two innovations changed the way financial economists view the value of stock picking. The first was the advent of electronic computing, which allows scientists to study mountains of returns data.
The second innovation was the Sharpe/Lintner capital asset pricing model (CAPM). Computers allow scientists to test whether markets efficiently priced securities based on the amount of risk that an investor couldn’t get rid of through diversification.
But, arguably, the most important innovation in the science of mutual fund analysis was the movement of a young scholar named Eugene Fama from romance languages into economics. Fama’s Ph.D. thesis in 1965 used the power of advanced computing to show that stock prices tended to follow a random walk. Fama also contributed to developing a new method of analyzing how stocks respond to new information, and that provided a window into the remarkable efficiency of financial markets.
Next time: A Scientist’s View of Investing. Stay tuned!