Small-Cap And Value Stocks

We know that small companies are riskier than large companies. Therefore, the market prices small-cap stocks to provide higher returns than large-cap stocks. From 1927 through 2007, small-cap stocks have provided an annual risk premium of 3%. However, small-cap stocks have not always outperformed large-cap stocks. If they always outperformed, there would be no risk of investing in them relative to investing in large-cap stocks - and there would be no risk premium. For example:

• January 1969 - December 1974, small-cap stocks underperformed large-cap stocks by a total of 47%.
• January 1986 - December 1990, small-cap stocks underperformed large-cap stocks by a total of 33%.
• January 1994 - December 1998, small-cap stocks underperformed large-cap stocks by a total of 30%.

Further evidence of the risk of investing in small-cap stocks is that while the small-cap risk premium has been 3 percent, the annual standard deviation of the premium, at over 13%, has been more than four times the premium.

We also know that value companies are riskier than growth companies. Therefore, the market prices value stocks to provide higher returns than growth stocks. From 1927 through 2007, value stocks have provided an annual risk premium of 5%. However, value stocks have not always outperformed. If they always outperformed, there would be no risk of investing in them relative to investing in growth stocks - and there would be no risk premium. For example:

• March 1934 - March 1935, value stocks underperformed growth stocks by a total of 43%.
• June 1998 - February 2000, value stocks underperformed growth stocks by a total of 44%.

And, as was the case with the small-cap premium, the value premium is volatile. The annual standard deviation of the value premium, at just under 13%, has been more than 2.5 times the premium.

Risk Premiums And Investment Discipline

The bottom line is that the outperformance of stocks relative to Treasury bills, small-cap stocks relative to large-cap stocks and value stocks relative to growth stocks is not what economists call a free lunch - there are risks involved. And it is a virtual certainty that the risks will show up from time to time. Unfortunately, we cannot know when, or for how long, the periods of underperformance will last, nor how severe they will be.

It is during the periods of underperformance when investor discipline is tested. Unfortunately, the evidence suggests that most investors significantly underperform both the stock market and the very mutual funds in which they invest. Consider the results of a study by Morningstar. Morningstar found that in all 17 fund categories they examined, the returns earned by individuals were below the returns of the very funds in which they had invested. For example, among large growth funds, the 10-year annualized dollar-weighted return was 3.4% less than the time-weighted return (the return reported by the fund). For mid-cap growth and small-cap growth funds, the underperformance was 2.5% and 3.0%. Investors in sectors funds fared worse, with tech investors producing particularly disastrous results, underperforming by 14% per annum.¹ The reason for the underperformance is that investors act like generals fighting the last war. They observe yesterday's winners and jump on the bandwagon, buying high - and they observe yesterday's losers and abandon ship - selling low. It is almost as if investors believe that they can buy yesterday's returns, when they can only buy tomorrow's.

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