McLean Heuristics

For the year to date, Value and Small Capitalization company categories are underperforming Growth and Large Company stocks. So why do we believe in tilting portfolios toward Value and Small stocks, more so than most other advisors and wealth managers we see? Because we believe, and the data illustrates, that markets price securities in a way that compensates investors with additional return for that added risk.

It is important that we set expectations with our clients that small/value investing carries risk and that our portfolios will in fact have periods of underperformance. We expect this result from the risk and return relationship. If small company and value stocks always beat the market, then there would be no risk to the investor. While there will be periods of underperformance, over
the long run we expect that markets reward investors for taking on this additional risk. If this were not the case, then why would anyone invest in a riskier micro cap name, when they could simply buy Microsoft?  A review of intermediate to long term results shows us why.

Attached is a recently developed illustration showing the percentage of rolling time periods where value-oriented companies outperformed growth-oriented companies; and where small company equities beat large companies.  The analysis is presented for both US and International equities. Please note that we have never suggested portfolios be constructed to take outsized risks in any category. No matter the argument you can make for overweighting a category, you can be very wrong with that strategy over short periods of time. The extent of how wrong may cause a loss of faith in a strategy just when it may be poised for a recovery. Just as some were tempted to (and actually did) eschew international, value and small company stocks in the late 1990s, it is too
early to declare US large company growth stocks permanently dead as a category.  In spite of their extended underperformance through this past decade, history tells us that the future may be different for this sector. Right now, it may appear that gold is going to keep going up in price, that Apple just can’t lose given their future prospects, that interest rates have to go up, that real
estate is a poor investment and that Obama won’t win reelection, betting the farm on any of those events is not prudent.

Diversification with a tilt to International, Value and Small company stocks may increase short term volatility, but has historically produced stronger long term results. We believe that will continue to be the case.

MAMC’s Risk Analysis-Small Cap and Value Dimensions