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Buy the best performing stock sector for 87 years

Reprinted courtesy of MarketWatch.com.

To read the original article click here

If it makes good sense to invest in value stocks (it does), and if it makes good sense to invest in small-cap stocks (it does), why not combine the two and invest in small-cap value stocks?

Based on 87 years of performance data, it’s a sound strategy.

In fact, small-cap value stocks have (in the long run) far outperformed large-cap blend stocks, large-cap value stocks and small-cap blend stocks.

In the long run, small-cap value is the undisputed champion of these four major asset classes. But the operative phrase there is “in the long run.” Over shorter time periods, small-cap value stocks can be disappointing.

Some numbers: From 1928 through 2014, U.S. small-cap value stocks turned in a compound annual return of 13.6% (compared with 9.8% for the Standard & Poor’s 500 Index SPX, +1.26% ).

At 13.6%, an investment of $100 would have grown to more than $6.5 million over those 87 years (compared with slightly less than $350,000 for the S&P 500).

However, investors don’t actually achieve average returns. They get real returns, one year at a time.

In its best year, 1933, the small-cap value index was up 125.2%. (Pretty amazing for the middle of the Great Depression.) But only two years earlier, this asset class suffered a loss of 54.7%. I imagine that was bad enough to discourage all but the hardiest of investors.

So it’s a safe bet that a lot of people who understood the theoretical merits of small-cap value investing had their money (what was left of it) somewhere else in 1933. Too bad.

Those were the extreme years. In 59 out of the 87 years for which this data is available, small-cap value stocks had positive returns, with an average calendar-year gain of 34.6%.

That is very sweet music by any standards. There was a downside, of course: 28 losing years, with the losses averaging 16.6%.

Still, in roughly two of every three of the past 87 calendar years, small-cap value stocks were profitable. And the positive years were, on average, twice as good as the bad ones were bad.

Looking at historic investment returns that way, one year at a time, is interesting but not very useful. For serious long-term investors, 40 years is much more important than any one year.

From 1928 through 2014 there were 48 periods of 40-years, and in every case the small-cap value index had a compound return above 11%.

The worst 40-year performance started in 1928 and had a compound return of 11.8%. The best period started in 1975 and returned 18.9% — a stunningly profitable run for investors who were both lucky enough to invest in 1975 and determined enough to stick with it for 40 years.

More relevant for many people would be a 15-year history.

This data set contains 73 15-year periods. The best one began in 1975, returning a compound gain of 26.4%. The worst 15-year period, starting in 1928, resulted in a compound loss of 1.6%.

On average, small-cap value stocks returned 16.1% during the 15-year periods for which we have data.

Only five of those periods had returns of less than 10%.

In 93% of the cases, a 15-year investor in small-cap value stocks would have obtained a compound return of 10% or more, with the average being 17%.

I would never advise anybody to invest in small-cap value stocks individually. But fortunately, there are low-cost index funds that bundle them by the hundreds.

Among the Vanguard funds I recommend is the Small Cap Value Index FundVISVX, +1.50% This fund has been profitable in seven of the 10 most recent calendar years; in two of those years, 2009 and 2013, the returns were more than 30%.

It wasn’t all roses, however, during the very rough period we experienced in 2007 through early 2009. In its three most recent down years, the fund lost 7.1% (2007), 32.1% (2008), and 4.2% (2011).

Despite setbacks like that, this asset class has such a terrific long-term record that I have sometimes recommended that investors in their 20s consider investing in it exclusively — but only until they are 40. Then they should diversify into other asset classes to give themselves a smoother ride.

There’s no guarantee this will turn out to be a good recommendation, but the historical evidence certainly supports it.

For most people, small-cap value stocks should be just one part of a diversified portfolio. In its good years, this asset class will surely provide “a piece of the action.”

And when these stocks are struggling, the probability is high that other asset classes will mitigate the damage.

In the next article in this series, I’ll show you the historical results from a portfolio with equal amounts of large-cap blend, large-cap value, small-cap blend and small-cap value.

We will see that over the last 87 calendar years, by virtually all measures of 15-year and 40-year periods, this combination of four asset classes outperformed the S&P 500 index alone.

You’ll see that this combination could triple the lifetime return of the equity part of your portfolio.

For more on small-cap value investing, check out my podcast, “What’s wrong with Vanguard SC Value?”

Richard Buck contributed to this article.