Which Equity Classes Will Outperform?

In the past few weeks, I have written a few Long Run columns on asset allocation (I still have more to do, including a piece on using index funds to achieve a diversified portfolio). One common question, often in two parts, I have received from readers is: What are the major asset classes and which ones will perform better than others?

Of course, I don't have a reliable crystal ball -- and a mere English lit major may not be the ideal person to answer market-timing questions. Nonetheless, with a little Web-trolling and boning up on long-term investment books such as Jeremy Siegel's Stocks for the Long Run , a reasonably intelligent investor can determine the basic asset classes and their historical returns -- even a broad sense of how the classes may perform over the next 20 years. As a financial writer I also have the advantage of time and access to professionals, so I thought I would answer this question. In today's column, I'll discuss the major equity classes -- part two will discuss fixed-income classes.

Before we detail the major asset classes, a basic point and two historical truths of long-run investing. First, the basic point: You don't need exposure to all the classes. Ibbotson Associates, the Chicago-based asset allocation consultant, has said that spreading assets across eight to 13 asset classes provides the optimal diversification, but for most investors -- those with less than $100,000 even -- it doesn't necessarily make the most sense to spread it out over 13 asset classes.

"You're spread too thin -- and you'll face higher fees, too," said Peng Chen, Ibbotson's director of research. Investors can achieve adequate diversification with five asset classes: large-capitalization domestic stocks, smaller-cap stocks, international stocks, bonds and cash.

Truth #1: Stocks will outperform bonds, bonds will outperform cash. This may not be true on a quarterly or even yearly basis, but it has been true for the past 200 years and may remain true for another 200. Why? It's a matter of risk and reward. Investors are compensated for taking on more risk -- stocks are riskier than bonds, and so on. "Over the long run, investors will be compensated by the amount of risk they are taking on -- that's the fundamental principle," Chen says.

Truth #2: Small outperforms large, value outperforms growth. Small stocks have posted a compound annual return of 12.1% since 1926, compared with 10.2% for large-cap stocks, according to Ibbotson. Once again, it's a risk-reward situation: Smaller companies carry greater risks than established companies, but offer greater potential rewards.

Let's Get Small This chart, showing the rolling real 20-year returns for large and small stocks, illustrates that the big-cap heyday of the late 1990s was something of an anomaly.

Source: Bear Stearns Asset Management

Market history also shows that value stocks outperform growth stocks -- this is true among small, medium and large companies. Why? There are many explanations, including behavioral matters. Investors tend to get overexcited about growth companies' prospects and bid them up excessively. "Storybook stocks such as Intel(INTC Quote) or Microsoft(MSFT Quote), which in the past provided fantastic returns, capture the fancy of investors, whereas firms providing solid earnings with unexciting growth rates are neglected," writes Siegel in Stocks for the Long Run.