Rules of the Game: Blend Large and Small

 | Jan 17, 2014 | 1:00 PM EST
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The other day I went on a rant about global diversification. I really do find it galling that the U.S. financial media -- cable channels, magazines, newspapers, blogs, the whole kit and caboodle -- have such a myopic focus on domestic large-cap (with occasional nods to smaller IPOs if the company is somehow deemed "interesting").

I've discussed the need to diversify beyond our shores. But that's only part of the equation. What about market cap?

I alluded to it above, but to clarify: I'm not suggesting that we should avoid U.S. large-cap. In a word, that would be stupid. Actually, two words: Epically stupid.

Large U.S. companies do pretty well in terms of total return.They are well managed and have tight corporate governance controls. Please don't make a fool of yourself by whining about "scandals" or "greed." U.S. companies are well governed and regulated, as a whole. Gross malfeasance is the exception, not the rule, and the system flushes out bad behavior pretty efficiently. If you believe otherwise, you have been bamboozled by media hysteria.

Moving along.

In addition to the Apples (AAPL) and Chevrons (CVX) and McDonald's (MCD) of the world, you want exposure to smaller companies. Not just for the sake of diversification, but because rigorous, scientific research has proven that small and value outperform large and growth. Why? It really doesn't matter. The effect is there. In academic terms, it's called a factor. A factor is an effect that's consistent across markets and across timeframes.

Think of it like this: imagine there's some kind of cholesterol medication that is extremely effective in New Mexico. Everybody in Albuquerque and Santa Fe has dramatically lowered cholesterol levels by taking this med. But in Indiana, it just doesn't work. Nobody in the Hoosier State is seeing any kind of improvement. It's a ridiculous example, but it illustrates the absence of a factor. There are no data to prove a consistent effect.

Here are some stats from Dimensional Funds that illustrate why you want to push factors in your investments: between 1927 and 2012 (a pretty decent data set!), U.S. large value posted an average return of 11.64%. The average return of the S&P 500 was 9.82% and U.S. large growth was 9.25%.

Turning to small-caps, domestic small value stocks advanced 19.13% between 1927 and 2012. Meanwhile, an index of the smallest half of NYSE stocks gained 15.75% and domestic small growth showed a return of 13.25%. The danger in an illustration like this is that people will want to put their entire portfolio in U.S. small value. "That's the best!"

Not so fast, my friend. (You can tell I miss college football season already.) The point is not to go all-in on any particular asset class. That would constitute a bet. The point is that you want to be in a position to participate in gains when and where they occur.

These days, some investors are irritated with themselves in hindsight for not being 100% invested in the S&P 500 in 2013. It was up more than 30! Why wasn't everybody all in? If you recall, the entire year was plagued by brilliant prognosticators and talking heads predicting an imminent crash. That stuff makes good media, but lousy investing strategy.

By the way, why the obsession with the S&P? Where is the widespread self-flagellation over missing out on the 480% gain on the Venezuelan IBC index? Oh, the humanity!

You get my drift?

It's important to tilt toward small and value, since these are proven factors that drive market performance. However, if you had completely avoided domestic large cap in 2013, you would have missed out on the S&P gains.

It's about having a philosophy and a plan, rather than bouncing around from one so-called "sure bet" to the next.

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