The September issue of Financial Advisor magazine contained an article about research done by Gary A. Miller, CFA, the founder and chief investment officer of Frontier Asset Management. The research called into question the long-held belief that, historically, small-cap stocks have beaten large-cap stocks on a risk-adjusted basis. Through his research, Gary discovered that, in fact, large-cap stocks have beaten small-cap stocks.
Since the publication of Gary’s findings, we have been asked to explain the implications of his discovery. What does it all mean? What should investors do with this information? We thought we would share our thoughts on these questions.
The most obvious implication of Gary’s research is that there is no reason to overweight small-cap stocks in a portfolio. Firms like DFA and others have long promoted the benefits of overweighting small-cap stocks because of the edge they purportedly had over large-cap stocks. There is no justification for doing that based on Gary’s findings.
Small-cap stocks still have their place in a well-diversified portfolio. Over certain time periods, they do deliver higher absolute returns than large-cap stocks, although they are riskier. In addition, small-cap stocks are not perfectly correlated with large stocks, so they provide some diversification benefit as well. We will continue to use small-cap stocks in our portfolios.
The most important lesson to be learned from Gary’s research has nothing at all to do with small-cap stocks. It has to do with the nature of investing and the attitude we should take toward the accepted truths that underlie our activities as investment managers.
Albert Einstein was a pretty smart guy. In 1905, he came up with the special theory of relativity summarized in the famous equation E = mc2. I don’t know about you, but the special theory of relativity is a little above my head. One thing I do know, however, is that under that theory nothing is supposed to be able to move faster than the speed of light.
Recently, a team of scientists based in Geneva, Switzerland, clocked some neutrinos breaking the speed limit. That is, they were moving faster than the speed of light. Neutrinos are subatomic particles that, under the special theory of relativity, should not be able to move quite that fast. Too early to tell for sure, but it looks like Einstein’s theory may have some holes in it.
The findings of the Swiss scientists remind us that accepted truths occasionally turn out to be more accepted than they are true. The “fact” that the world is flat and that the sun revolves around the Earth are examples. There is no reason to believe that some basic investment truths are not similarly flawed.
I believe this is the most significant implication of Gary’s research. His findings remind us that what we take as truth in the investment world may be worth questioning periodically. There are a number of reasons for this.
“Truth” can be highly dependent on the tools and methodologies you use to discern it. This is demonstrated in Gary’s work on the small versus large question. By using slightly different (and we think better) data, measurement tools and methodologies, Gary turned a long-held belief on its head. Tightening up the analysis just a bit produced dramatically different results.
A related issue is the subject of time-period dependency. Conclusions about “truth” in the investment world can be highly dependent on the time period you are examining. What is demonstrably true looking at one time period may be totally untrue if you simply flip a few pages on the calendar. This is a hazard whenever we look back at historical performance.
Another reason to periodically re-examine the foundations of our craft is that our world does, in fact, change over time. Now, it is unlikely that neutrinos have gotten faster since Einstein’s day. They have probably always been faster than the speed of light, or else they have never been and never will be faster than light. But in the investment world, things truly do change.
This brings us to some other research Gary has been doing that has not been published yet. For those of you who have read Jeremy Siegel’s book, Stocks for the Long Run, you know that the long-term historic real return of stocks is about 7%. Other credible investment professionals have pegged that number at closer to 6%, although depending on what time period you look at, a case can be made that it is as high as 8% (see 1926 to 1999, for example).
As Gary sifted through the data, he realized that over the last 50 years or so (1960 to 2010) the real return of stocks has averaged just over 5%-or 2% lower than Siegel’s number. So the question arises, when does an average return of 5% for stocks stop being an anomaly and become the new reality? What is truth and what is just an aberration? Time will tell.
The point is that part of our job as investment managers is to continuously question accepted wisdom. We can never rest on our laurels and think we have got it all figured out. Especially in a world where much of the “truth” that is offered up comes from product manufacturers and salesmen, a healthy skepticism and an insatiable curiosity are essential.
I’m sure there are some immutable truths of investing-it’s just not always clear what they are. So we will keep asking questions and turning over stones to see what we find. If we all do that, together we’ll find other investment “truths” that are ready for the dustbin of history and our clients will be better off for it. We doubt that speeding neutrinos will have any impact on the financial markets or our clients’ portfolios, but we’ll keep our eye on them too.