Q: Wow, you are extrapolating the past into the future there. Very creative analysis! Or wait… wait a second! Wasn’t all this extrapolating the past into future one of the behaviors that led to massive losses during the financial crisis?
A: I can guarantee the future will not look like the past. Not the next week, month, year or decade. If I could guarantee the future would look like the past, I would recommend investors put all their money in small cap value. Better yet, let’s go back to 1986 and put all of our money in Microsoft. There is no risk in the past. We all know exactly what we should have done.
I know what small cap value has done in the past. I know if from all of the tedious work done by the academic community. I don’t trust Wall Street, I don’t trust Main Street (friends and family) but I do accept the hard work done by the academic community (I call University Street), which gives us the best sense of relative returns. The academics are very clear about the expected returns of small cap value.
They believe small cap value is very likely to make more than small cap growth (over 4% more per year since 1927) but they refuse to say what the return will be. They also believe small cap value will make more than large cap value (over 2% per year since 1927) but they refuse to predict what the future return will be. Their belief is that investors should get a premium for stocks over bonds, small stocks over large, and value over growth. They make no attempt to tell you what future returns will be, but are willing to report on what they have been.
Most people think that recent returns (one, five, 10, maybe even 20 years) are meaningful. I like 50 to 80 years. In fact, if investors had used 50 to 80 years they would not have been surprised by the losses in the bear markets of 1973-1974, 2000-2002 or 2007-2009. They all looked very much like the past.
The purpose of my article was simply to suggest that small cap value should be one of many asset classes in a properly diversified portfolio. Yes, I like having the past on my side, but my own portfolio is a combination of over 12,000 stocks (through index funds) – approximately half in stocks, half in bonds, half in growth, half in value, half in large, half in small, half in international, half in U.S. half in buy and hold and half in market timing. Your comment is exactly the thinking that led me to this massively diversified portfolio. I don’t trust the future to look like the past.