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 |
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