This is why almost everyone should invest in small-cap value funds

Over the past few years I have become more and more convinced that for many investors — perhaps even most investors — can benefit from focusing on small-cap value funds in their equity portfolios.

Small-cap value funds combine smaller companies (which historically tend to grow much faster than larger ones) and value companies, which have a long history (ironically) of outgrowing growth companies.

To make sure we’re on the same page, I want to define our terms.

A small-cap stock is generally a company with a market capitalization of between $300 million and $2 billion, although there are funds called “small cap” in which the average size company is higher.

Value companies are often regarded as ones that are out of favor with institutional investors. The measure of a company on the growth-to-value spectrum is usually the price-to-book ratio, and sometimes the price/earnings ratio.

Lower ratios indicate deeper discounts (bargains in the stock market, in other words) and higher expected returns.

The price/earnings ratio of the average small-cap growth fund is 28.3, vs. 19.8 for small-cap value funds. The average price-to-book ratio of small-cap growth funds is 3.7, vs. 1.7 for small-cap value funds.

Not surprisingly, small-cap value stocks have historically outproduced other major asset classes.

Lots of investors and advisers worry about the volatility of small-cap value stocks. But the best research I know has led me to believe that this worry is overblown.

When I recommend small-cap value funds, some people seem to think I’m trying to lead investors “over a cliff” in search of high returns without regard to risk. Not true.

Personally, I am risk-averse. I take every risk extremely seriously, and I am willing to work hard to eliminate those that I can.

I have absolutely no desire to advocate high-risk investments, unless there’s a high probability for significantly higher returns.

It’s important to understand that risk comes in more than one flavor.

For many investors, the risk of inflation — hence the risk of returns that are too low — is considerably more significant than the risk of short-term bumps in the road.

When you’re invested in the stock market, there’s no way you can completely avoid risk.

If you think of “the stock market” as the S&P 500 index US:SPX, you could think of the risk of that index as “normal.”

Long-term small-cap value returns have been higher than this “normal,” and the risks have been higher as well.

But when you drill down into the data, you find that the short-term risks from small-cap value investing have been only 2% to 5% more, while long-term returns have been much higher.

I always prefer to back my assertions with data, and fortunately we have nearly 90 years of it, going back to 1928.

Let’s look at two major asset classes: large-cap blend (like the S&P 500) and small-cap value.

From 1928 through 2016, the S&P 500 index compounded at 9.7%, while small-cap value stocks grew at 13.5%.

To achieve returns like those, investors had to persevere through some pretty difficult years. In that long period, the worst calendar-year losses were 43.3% for the S&P 500 and 55.5% for small-cap value stocks — in each case the year was 1931.

That comparison is no surprise to those who understand that return and risk go together.

But if you’re being warned about the worst of times, it’s only fair to contemplate the best of times, too.

The highest one-year returns came just two years later, in 1933, with gains of 54% for the S&P 500 and 125% for small-cap value stocks. (And the investors who bailed out of the market after 1931, perhaps vowing “never again,” missed out on those big 1933 gains.)

Long-term investing, of course, doesn’t center on single-year returns. For many investors, a 40-year span is reasonable, especially since many people will have money invested for 25 or more years after they retire.

Fortunately, we have data that lets us look at every 40-year period since 1928. I think the numbers are very instructive.

Taking all those periods into account, the S&P 500’s average 40-year return was 10.9%, considerably less than the 16.2% average for small-cap value stocks.

The best 40-year period: 12.5% for the S&P 500 and 19% for small-cap value. The worst 40-year period returns were 8.9% and 11.6%, respectively.

Look at those numbers again, and you’ll see that the very worst 40-year record for small-cap value stocks (11.6%) was nearly as high as the very best record for the S&P 500 (12.5%).

The results were more variable with individual years. In fact, there were eight single years in which the S&P 500 made money and small-cap value stocks had losses. But on the other hand, in four of the 24 years in which the S&P 500 lost money, small-cap value stocks actually made money.

Here’s a point that should not be overlooked: For long-term investors (40 years or more), all these losses were temporary. Yet the long-term gains were permanent, at least for those who stayed the course.

Applying average 40-year returns to an initial investment of $1,000, we get ending values of $62,699 in the S&P 500, vs. $405,737 in small-cap value stocks.

To my mind, this is life-changing information, even when it is applied to only part of a portfolio.

I would like nothing better than to get this information and these insights into the hands of trustees of corporate 401(k) plans.

I have reviewed more than 100 such plans, and many don’t even offer small-cap funds, let alone small-cap value funds.

Read: 10 things successful investors don’t do

Yet when employees are being denied traditional pensions and told to make their own investment choices, I cannot think of any sensible rationale for depriving them of investment options that could make the kind of long-term differences we’ve seen in small-cap stock funds.

So if you’re an individual, what should you do?

If you’re in a retirement plan that offers one or more small-cap value funds, I think you should have some part of your money in those funds, even if the rest is in a target-date retirement fund. Here’s an article on that idea.

If your retirement plan does not offer small-cap value, then you should consider diverting some of your savings to an IRA, where you’ll be able to choose a low-cost small-cap value index fund or ETF. (Don’t divert savings until you have maximized whatever employer match you’re entitled to, however.)

Read: How to talk to your family about your estate plan

Here’s one more interesting point about small-cap value stocks: Some recent research by my colleague Chris Pederson shows that this asset class recovers from adversity more quickly than the S&P 500.

His report is titled “Resiliency – How Fast Do Different Asset Classes Recover?” It’s worth reading.

For more on small-cap value investing, listen to my podcast: “10 reasons small cap value is a life changer.”

Richard Buck contributed to this article.

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