Asset Allocation in Action–Small Cap vs. Large Cap Mutual Funds

As we saw in Day 2 of this series, small cap stocks historically have enjoyed higher returns than large cap stocks. From 1926 to 1998, small caps have averaged a 12.18% return, while large caps have returned about 11.22%.

Of course, small caps are more risky. The standard deviation for Vanguards S&P 500 Index is 7.35% according to Morningstar, while Vanguards Small Cap Index fund has a standard deviation of 12.21%. As a refresher, standard deviation tells us that about two-thirds of an investment’s yearly returns will fall somewhere between its average return – its standard deviation on the one hand, and its average return + its standard deviation on the other. Using the numbers above, two-thirds of the S&P 500’s returns will fall between 3.87% (11.22 – 7.35) and 18.57% (11.22 + 7.35). In contrast, two-thirds of the Small Cap index fund’s returns will fall somewhere between -.03% (12.18 – 12.21) and 24.39% (12.18 + 12.21). Thus, the higher the standard deviation, the more volatility you can expect in the investment.

So what’s this mean for asset allocation? My approach has been to invest about 20% of my portfolio in small caps (including both domestic and international). The idea here is to benefit from what I hope will be higher returns from small caps, while not going overboard and greatly increasing the risk of my overall portfolio. I split my small caps into three funds:

Bridgeway Ultra-Small Company Market (BRSIX): This fund invests in ultra small cap stocks, and its current holdings have an average market cap of $362 million.

Allianz NFJ Small Cap Value Instl (PSVIX): This fund invests in small cap stocks, and its current holdings have an average market cap of $2.11 billion. This fund is really on the borderline between small cap and mid cap.

Vanguard Explorer Fund (VINEX): This fund invests in international small cap and mid cap stocks, and its average market cap is currently $1.863 billion.

The point here is not to recommend these funds or my asset allocation. Rather, the point is simply to show you the choices I’ve made, which may or may not be appropriate for you. You should note from the above information, however, that not all small caps are created equal. You’ll see in the above funds that within the small cap category there is great variance in the size of the companies these small cap funds actually own. The Allianz fund market cap is several times larger than the average market cap for the Bridgeway fund. The point is that you need to look at the average market cap of the fund, rather than relying on the name of the fund, as the name can be deceiving. The risk, as measured by their standard deviation also can vary significantly from fund to fund. The standard deviation for the Bridgeway fund is 13.52%, while the other two funds have standard deviations of about 10.50%. This is to be expected given that Bridgeway invests in significantly smaller companies.

How does my allocation stack up against the pros?

You’ll see a lot of recommended asset allocations in books and published articles. Generally, for those with at least 10 or 20 years to go before retirement, the suggested allocations that I’ve seen range anywhere from about 10 to 25%. For example, Bernstein in The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk suggests 15% for a long-term portfolio. The Bogleheads in The Bogleheads’ Guide to Investing recommend 25% allocated to mid cap and small cap for a young investor, and about 15% for us middle-aged folks.

One critical thing to keep in mind is that if you own a small cap fund, be prepared to lose some money in the short term. As we’ve seen from the standard deviation, these funds are more volatile than large cap and bond funds. So if you can’t stand the heat. . . .

Topics: Asset Allocation

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