You’re Huge, Bro!

During my football playing days in high school and college I spent hours in the gym lifting weights.  My teammates and I lifted weights during the regular and off-season and mostly followed a structured program outlined by our coaches. On occasion we’d go off script to see who could “max-out” on the bench press.  These “max-out’ sessions were highly spirited with lots of yelling and screaming.  A few of my teammates would get so big from lifting weights they’d become less nimble.  Their large size helped in the gym, but it became a hindrance on the football field.

Small things can grow up to become big things.  The mustard seed is the tiniest of seeds, but it becomes a large plant of 9 feet or more.  Small companies can also grow into large companies.  Amazon, Apple, Berkshire Hathaway and Facebook were once small companies.

Investors often focus on large companies when constructing a portfolio and pay little attention to small companies.  Asset allocation models generally recommend investors allocate 30% to 50% of their assets to large-cap companies while committing 5% to 15% of their principal to small companies.

The main reason to allocate a portion of your assets to small-cap stocks is that they’ve outperformed large-cap stocks over time.  The Dimensional Small-Cap Value Index has generated an average annual return of 13.5% since 1928.  A $1 investment in this index was worth $78,639 at the end of 2016.[1]  The Dimensional Large-Cap Value Index returned 11.3% during the same time frame and turned $1 into $13,591.[2]  The small-cap index outperformed the large-cap index by a factor of 5.7 to 1.

What exactly is a small-cap stock?  The definition of a small-cap varies but it mostly includes companies with market caps below $1 billion.  By comparison, the market cap for a mega-cap stock is north of $200 billion.

Small-cap stocks carry more risk than large-cap stocks so pay attention to the amount of money you contribute to this sector.  The standard deviation for small-cap growth stocks is 23.29% and for large-cap growth stocks it is 17.05%.  For example, if the expected return for the small-cap index is 10%, then the range is a positive 33.29% to a negative 13.29%.[3]

A search for small-cap stocks generated a list of over 10,000 names.[4]  Rather than sifting through this long list I’d recommend investing in a small-cap mutual fund or ETF[5].  Here are a few suggestions.

DFSTX – DFA Small Cap Index.  A $10,000 investment in 1992 is now worth $135,435.

DFSCX – DFA Micro Cap Index.  A $10,000 investment in 1981 is now worth $594,395.

DISMX – DFA International Small Cap Index.  A $10,000 investment in 2012 is now worth $17,335.

IJR – iShares S&P 600 Small Cap Index.  A $10,000 investment in 2000 is now worth $57,418.

IWM – iShares Russell 2000 Index. A $10,000 investment in 2000 is now worth $39,268.

VB – Vanguard Small Cap Index.  A $10,000 investment in 2004 is now worth $33,841.

As you pump up your portfolio, don’t ignore the 90-pound weakling because it may grow up to become a big, mighty juggernaut.

And he said, “With what can we compare the kingdom of God, or what parable shall we use for it?  It is like a grain of mustard seed, which, when sown on the ground, is the smallest of all the seeds on earth, yet when it is sown it grows up and becomes larger than all the garden plants and puts out large branches, so that the birds of the air can make nests in its shade.” ~ Mark 4:30-32

Bill Parrott is the President and CEO of Parrott Wealth Management, a fee-only, fiduciary financial planning and investment management firm.  For more information, please visit www.parrottwealth.com.

November 1, 2017

Note: Your returns may differ than those posted in this blog.  Past performance is not a guarantee of future performance.

 

[1] Dimensional Fund Advisors 2017 Matrix Book.

[2] Ibid.

[3] Morningstar Market Assumptions. One Standard Deviation.  (10 + 23.29 = 33.29); (10-23.29 = -13.29)

[4] Fastgraphs.com Charts, website accessed 10/31/2017.

[5] Morningstar Office Hypothetical.  Inception date of the specific fund to September 2017.

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