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
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
, 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.
Of course, these general rules don't mean investors should drop bonds and cash, or even large-cap growth -- market timing, either in stocks or asset classes, destroys the efficacy of diversified investing. Once more, I'll defer to Siegel: "The average investor will do best by diversifying into all stock sectors. Trying to catch styles as they move in and out of favor not only is difficult, but also is quite risky and costly."
This asset class consists of companies with at least $5 billion in market cap that have increased earnings in the past well above the average company and are expected to continue to do so --
, for instance.
From 1968 to 2002, large growth has returned 10.4% a year, according to Ibbotson.
This class performed phenomenally well in the 1990s -- the average large-cap growth fund returned 30.28% a year from 1995 through 1999, according to mutual fund research firm Lipper. Many neophyte investors concluded that large-growth stocks were the best performers and all one really needs for the long haul. (Large-growth stocks soared and became extremely overvalued: By March 2000, six of the 20 largest U.S. companies had price-to-earnings multiples over 100.) The past three years have instructed otherwise.
What does the future hold for large-growth stocks? Most likely, a continuing process of reversion to the norm -- when an asset class performs way above its historical average, it typically enters a period of performing below its average. Bear Stearns Asset Management forecasts the real rate of return -- adjusting for inflation, which historically has added 2% to 3% to annual returns -- of the large-cap
through 2022 is 3% to 5% a year, and it expects large-growth to underperform large-value.
Large-cap stocks -- both growth and value -- constitute about 75% of the total domestic market. (Check out this
Five Funds article to learn about solid-performing large-cap growth funds.)
Companies in the large-cap value class have market cap of at least $5 billion and shares priced below the market --
, for instance.
Since 1968, large-value has returned 12.8% a year.
In the long run, large-value beats large-growth while offering less volatility, but this wasn't true during the 1990s. Large-value, while performing above historical norms, lagged growth: The average large-value fund returned 19.8% a year on average during the second half of the 1990s, according to Lipper.
Over the average rolling 20-year period since 1926, large-value's premium over large-growth is 4.34%, according to French-Fama data. In 1999, for the first time in more than 50 years, large value -- as measured by 20-year return -- trailed large-growth. At the bull market peak in March 2000 (remember
?), large-value's 20-year return dipped to 1.02% below large-growth.
What does this mean for large-value going forward? Many asset-allocation experts expect large-value will return to its traditional role of beating large-growth. But, large stocks across the board outperformed small- and mid-cap stocks in the 1990s -- that hasn't been the case over the long run, and it may not be the case during the next 20 years. Still, if the S&P 500 is expected to return 3% to 5% a year, large-value is likely to be the stronger portion of that index. (Check out this
Five Funds article to learn about solid-performing large-cap value funds.)
This asset class consists of companies with market capitalization between $1.5 billion and $5 billion who have increased earnings in the past well above the average company and are expected to continue to do so.
Since 1968, mid-cap growth has returned 7.3% a year, according to Ibbotson.
Mid-cap growth traditionally lags behind mid-cap value stocks, but that trend was reversed in the 1990s, in part because investors trolled the class looking for the next Microsoft or Dell among the
. Many mid-cap growth stocks swelled to large-cap status -- but post-bubble, they are back in this class once again.
Companies with less than $5 billion -- mid-cap, small-cap and micro-cap stocks of growth and value variety, or the non-S&P 500 companies -- make up about 25% of the total domestic stock market. Since the March 2000 peak, small-cap and mid-cap classes have trounced the large caps. Many market historians forecast that mid- and small-cap stocks are in the early stages of a multiyear rally. Bear Stearns Asset Management, for instance, forecasts the real rate of return of small- and mid-cap stocks will be 7% to 11% a year, well above forecasts for large-cap.
Companies in the mid-cap value class have market cap between $1.5 billion and $5 billion with shares that are priced below the market.
Since 1968, mid-cap value has returned 12% a year on average.
After trailing mid-cap growth for much of the 1990s, these stocks have held up much better so far this decade. Historical trends, as well as reversion to the norm, suggest that this asset class should perform well over the next two decades.
These stocks have market capitalization below $1.5 billion and earnings history and prospects that indicate growth exceeding the broader market.
Since 1968, small-growth has returned 3.2% a year on average, according to Ibbotson.
According to Jeremy Siegel, small-growth returns were the lowest of 25 categories analyzed from 1963 to 2000. (The best was small-value.) While this class has had some years of astonishing outperformance -- such as 1999, when the average small-growth fund returned 63.86%, according to Lipper -- it has historically lagged small-value.
What does the future hold for small-growth? Most likely, it will continue to lag its small-value peers. (Check out this
Five Funds article to learn about solid-performing small-growth funds.)
This asset class consists of companies with market capitalization below $1.5 billion whose shares trade below the broader market.
Since 1968, small-value has returned 13.1% a year.
Small-value, despite lagging larger stocks and growth stocks in the 1990s, has been the best performing equity sector over the long run. Also, "small value is the least correlated category with large-cap stocks, which helps investors diversify," said Morningstar analyst Scott Cooley. The sector has held up exceptionally well since the March 2000 peak.
What does the future hold for small-value? Small stocks historically outperform large stocks, but that relationship -- based on 20-year rolling returns -- reversed in the 1990s. (Check out this
Five Funds article to learn about solid-performing small value funds.)
This asset class has returned about 7.07% a year since 1970, if returns are measured by the best-known international benchmark, the MSCI-EAFE index.
The role of international stocks -- a self-explanatory asset class -- in building a diversified portfolio is under debate. Due in part to globalization, domestic and overseas markets move more in tandem -- the correlation between the two rose from 43% in 1992 to 73% in 2002, according to Ibbotson -- meaning international markets' role as a diversifier has been diminished. Some experts suggest an individual's international exposure can be achieved through ownership in large U.S. companies, such as
, that derive substantial portions of their revenue overseas. (The notion that investors can enhance their diversification through global sectors is discussed in
this recent column.)
Nonetheless, most experts say international stock exposure is still a vital component of a diversified portfolio. "The U.S. is the largest stock market, but the majority of the world's capitalization is in foreign stocks," said Ibbotson's Chen. "You certainly want some international exposure."
Stocks for the Long Run,
Siegel puts it more urgently: "To invest only in the U.S. is to ignore the majority of the world's capital. ... Sticking only to U.S. equities is a risky strategy for the long-term investor." International markets over the long haul perform similarly to the U.S. market, but with great deviations in shorter-term periods -- the extreme case being Japan's stunning rise during the 1980s, and the subsequent average annual decline of more than 6% during the 1990s.
"In the future, international will probably perform similarly to U.S., but it will also provide you with diversification," Chen said. (Check out this
Five Funds article to learn about solid-performing overseas funds.)
The emerging-markets asset class, a subsector of international stocks, includes stocks from developing-world nations such as Korea, Israel, Mexico and China. Since 1988, the class has witnessed compound annual growth of 7.41% a year, as measured by the MSCI-EMF index.
This has been an extremely volatile subset of international investing during its relatively short monitored history -- the global financial crises in the late 1990s created a great deal of volatility. Because there isn't a great deal of historical market data on emerging markets, it becomes even more difficult to make forecasts about future growth. Nonetheless, emerging market countries such as China and Korea show great promise for long-term growth.
The Bottom Line
What does this mean for investors' portfolios? While quantitative strategists can make reasonable assumptions about what asset classes are likely to outperform the broader market during the next two decades, that doesn't mean investors should throw out the asset allocation playbook and concentrate entirely on the classes poised to outperform.
Two of the biggest bull markets of the past 75 years came in 1932-1937 and 1970-1972, cyclical upturns during dreary overall periods. While large-cap growth stocks may underperform during the next 20 years, dumping them all now would spell trouble if we have a similar -- albeit short-lived -- growth-led bull run.
So, remain diversified, but consider tweaking your asset allocation -- lightening up on large growth, for instance, and boosting your small-cap exposure.
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