Small Caps Will Outperform If You Give 'Em Time

Includes: IJR, SPY, VB, VTI
by: Dale Roberts

One could speculate that the majority of investors who read and write and comment on Seeking Alpha are in the accumulation phase. And when one is in the accumulation phase and has a long-term investing horizon, the only thing that matters is total return. One may have the (eventual) goal of turning that total return into income for spending in retirement or a form of semi-retirement, but until that moment of harvesting for income arrives, the only thing that matters is wealth creation. The most important metric will be how much money do you have to go shopping for that income. The more money, the greater the income and a more generous lifestyle will be delivered in retirement.

Many investors are using the income from stocks and bonds to drive total return, and to manage risk. And that's prudent. I write often that the most important move an investor can make is to pay real close attention to his or her risk tolerance level and match their investments to that risk tolerance level. Certainly, most money is lost or left on the table due to the fact that investors take on way too much risk, and then sell at the bottom when the going gets tough. From my observations and readings, most investors cannot handle a portfolio that is heavily invested into stocks. Heck, a large majority of investors cannot even handle a typical balanced portfolio of stocks and bonds.

That said, there is a slice of the investing world that can handle risk; lots of risk. They can take on all of the twists and turns and ups and downs that the markets can throw at them. There are investors that embrace a 30, 40 or 50% drop in the markets and get greedy and buy while others are fearful. Those investors would be better served to adopt the strategy that historically delivers the greatest total return. There's no guarantee of results when we look into the future, but what option does an investor have but to look back, adopt a proven strategy and hope that history repeats itself?

As I wrote in this article, Skip the Dividends If You're Young and Brave, a young investor with a high risk tolerance level should likely skip the dividends and go directly to the small and mid cap world to generate gains well beyond those of the broader large cap market such as the S&P 500 (NYSEARCA:SPY).

Here is a long-term chart from that article.

That chart demonstrates that small-caps do outperform over a very long period. But, of course, very few of us invest over 70 year period. Perhaps the majority of investors will create the bulk of their wealth over a 25 or 30-year period. That's a very long-term investment horizon. And it is time that increases the probability that historical performance will be given the chance to repeat itself.

As a reader pointed out in regards to my skip the dividends article, it's not a given that small caps will outperform, and that there are periods when small caps will underperform the broader market.

I presented a chart that shows how the small caps have been doing their thing recently. They've been on a tear. Here's iShares small cap ETF (NYSEARCA:IJR) vs. SPY over the last 13 years.

That reader pointed out:

Go back 20 years and 25 years and the Russell 2000 has underperformed the S&P 500. And going back to 1926 is useless unless you analyze rolling time periods.

I would agree. We should look at how often small caps will outperform historically, and how long one needs to remain invested to increase the likelihood of that outperformance.

Here's a chart that highlights the periods of under and over-performance of small caps vs. the large caps.

The trick of course is to hitch a ride aboard the small cap train when they deliver one of those periods of dramatic performance. You may even need only one of those events in your investment "career" to set you up for the future.

And here's a chart that breaks it down by length of holding period.

We can see that when one is investing for 20 or more years, small caps are historically a pretty good bet. The outperform likelihood moves to 100% for 35 and 40 year periods.

And here's that statistical breakdown with reinvestment 'along the way'.

We now see that in the accumulation phase and with funds reinvested every year that the time required to get that historical guarantee of outperformance is shortened to the 25 year period.

If history is a guide, small caps with deliver the generous total return many young investors seek. If you can handle the additional risk or volatility, this may be the route to the highest potential total return. I see many young investors drawn to the dividend growth strategy as dividends get a lot of well deserved press these days; but remember that income is not required to spend in the accumulation phase, it is therefore a non-event. The same holds true for an investor that embraces a high yield strategy in the accumulation phase that might include dividend stocks, bonds, high yield bonds, preferred shares and perhaps REITs and MLPs. Using income to drive total return can be nothing more than a useful distraction. Using bonds and dividend growth only really makes sense if one is managing risk. For those who have a higher risk tolerance level they will likely be "better off" if they adopt a total return strategy.

Investors can easily chase these greater total returns with a few ETFs such as iShares small cap ETF IJR or Vanguard's VB. One might also choose the path of investing in the total market that includes the large, mid and small caps in one basket. On that front Vanguard offers VTI for total market exposure. The total market can offer a modest outperform in certain periods thanks to the small and mid caps.

Investors can certainly select their own equities, and in the small cap world that may present more opportunity for gains beyond the index, or more opportunity for errors and mistakes. Small caps are certainly less predictable than large caps. There is there is the likelihood of more massive home runs and more flame outs. It would take an incredible amount of due diligence, patience and nerve to manage your own portfolio in this space.

I would advise against it as I don't see the majority of large cap or dividend growth stock pickers matching the broad market index returns. IMHO opinion it would be even more of a challenge to perform as a stock picker in the small and mid cap world; but certainly to each his own. The potential gains are sitting there available with three letter ETFs. From there, all you would have to do is manage your risk and time horizon and your exit strategy. The transition to an income portfolio can be as easy as 1-2-3 ETFs as I demonstrated in this article. That article shows how any easy 3-ETF portfolio wins the day over stock selection for income. In the drawdown phase it is my opinion that the traditional income portfolio using the many tools of income from REITs to high yield bonds will continue to be the best bet, with a portfolio delivering more income than a traditional dividend growth portfolio. The total income portfolio can also deliver the required income growth to beat inflation.

And of course, one may pursue other growth total return strategies or sectors such as investing in the Nasdaq index, bio techs, technology companies and ETFs or other proven areas of growth. One may conclude that there are better growth prospects in the developing nations and go that route as well. There are many ways to seek and hopefully find that total return.

Again, if you are young and brave, do yourself a favor and skip the dividends.

Disclosure: I am long SPY, DIA, VYM, EFA, EWC, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. The Streetwise Portfolios offer index-based complete portfolios to Canadians. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.