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Small to Large: Too Much of a Good Thing May Hit Your Portfolio

Stocks in this article: IWM SPY

If they end up being accurate once again in today's market, the implications are significant. Given the 15-year run in small-caps, many investors likely have an outsized weighting to the asset class in their portfolios due to price appreciation alone. Additionally, as most investors suffer from recency bias -- a tendency to chase recent performance -- any new purchases made over the past few years were likely to favor small-caps.

What can an investor do to prepare for the likely reversal in the years to come?

First, a simple rebalancing out of small-caps and into large-caps would bring an investor's portfolio back in line with their target allocations. A more active investor may consider going beyond rebalancing by reducing their target allocation to small-caps until the valuation gap is closed.

A final re-positioning for aggressive long-term investors to consider would be to reduce their exposure to U.S. small-cap stocks and increase their exposure to the "small-caps of the world," emerging market equities through the iShares MSCI Emerging Markets Index (EEM). According to Grantham, emerging-market stocks are projected to deliver a real return of 3.5% per year over the next seven years, or 8.4% higher than their projected return for U.S. small-caps.

At the time of publication the author had no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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