Historically, small cap and value stocks have outperformed their large cap and growth stock counterparts across US markets, non-US developed markets, and emerging markets. As a result, investors have come to expect this pattern to continue, which is why the outperformance of large growth stocks (e.g., Apple, Google, Amazon, etc.) over the past decade has many financial commentators wondering if there is still a premium associated with investing in small cap and value stocks.
In an uncertain world, just because you expect one variable to outperform another does not mean it is going to happen. For instance, we would expect the better sports team or horse to win a higher percentage of the time, but that does not make it impossible for the 50-to-1 long shot to win the Super Bowl or the Kentucky Derby. Similarly, based on analysis from Dimensional Fund Advisors (DFA), US small cap stocks outperformed US large cap stocks 55% of the time over rolling one-year periods starting in June 1927 and ending in December 2020. If we increase our rolling periods to ten years, US small cap stocks outperformed US large cap stocks 71% of the time, which explains why we need to invest over longer time periods to reap the benefits of the US small cap stock premium. But this analysis does not mean that over a future ten-year period US small cap stocks will outperform – just that we expect them to outperform. Remember that even over these rolling ten-year periods, US large cap stocks outperformed US small cap stocks 29% of the time.
We can run through a similar exercise with US value and US growth stocks. Based on the same DFA study and the same period (June 1927 through December 2020), US value stocks outperformed US growth stocks 59% of the time over rolling one-year periods, and 81% of the time over rolling ten-year periods. Again, holding US value stocks over longer time periods gives us a better chance of benefitting from the expected outperformance, but even over rolling ten-year periods, US growth stocks still outperformed 19% of the time.
This historical data helps give us perspective on the current underperformance of small cap and value stocks and guides our understanding of what to expect in the future. For example, if you had a biased coin where you expected heads 60% of the time and tails 40% of the time, the smart bet would be on heads each time. While you would experience a loss 40% of the time, over enough throws, you would win more often than you would lose.
In our opinion, this is the essence of investing, but when you invest, you can build a portfolio that allocates more to the heads (e.g., small cap and value stocks) while still maintaining exposure to tails (e.g., large cap and growth stocks). This allows you as an investor to benefit from the long-term expected outperformance of small cap and value stocks while not forgetting about the benefits of diversification that come from exposure to large cap and growth stocks – because we know that there will be years (even decades) when these asset classes outperform.