One of the most hotly debated topics among passive investors is whether or not it’s advantageous to “tilt” your asset allocation toward small-cap or value stocks rather than using simple “total US stock market” and “total international stock market” funds for the stock portion of your portfolio.
To understand the argument in favor of overweighting small-cap and/or value stocks in your portfolio, we first need to back up a step.
A Bit of Finance History
From the 1960s to the early 1990s, the Capital Asset Pricing Model (CAPM) was the prevailing method for understanding the expected returns of a portfolio. CAPM stated that the expected return of a portfolio should be proportional to the amount of market risk the portfolio takes on.
In 1992, however, Eugene Fama and Kenneth French published a paper pointing out that portfolio returns were influenced (surprisingly reliably) by two additional factors:
- The market capitalization of the stocks in the portfolio (i.e., are they big companies or small companies?), and
- The “book to market” ratio of the stocks in the portfolio (i.e., are they growth stocks or value stocks?).
The conclusion: A portfolio’s expected return increases not only as a result of increasing the allocation to stocks in general, but also as a result of increasing the allocation to small-cap stocks and/or value stocks. This concept became known as the Fama French 3-Factor Model.
But Why Bother?
A clever reader might wonder why would anyone want to increase the allocation to small-cap stocks or value stocks rather than just increasing the allocation to stocks overall.
The answer is found in another historical observation: These three risks (market risk, small-cap risk, and value risk) have tended to have low correlations to each other. That is, they tend to be detrimental at different times, thereby making them useful diversifiers for each other.
For example, rather than building a portfolio dominated by market risk (i.e., a portfolio whose stock allocation is mostly a “total stock market” holding), an investor could decrease his market risk (by decreasing his stock allocation) and increase his allocation to small-cap and/or value stocks. Historically, such a change would often result in a reduction of overall volatility without a reduction in return.
Is It a Market Inefficiency?
Some investors argue that the historical outperformance of small-cap and value stocks is (mostly) a market inefficiency that we shouldn’t expect to persist now that it’s so well known. The line of thinking behind this criticism is that the additional volatility of small-cap stocks relative to large-cap stocks and value stocks relative to growth stocks is not sufficient to justify their much higher historical returns.
As counterpoints, proponents of the 3-Factor Model argue that:
- Small companies are riskier than big companies and value companies (those in declining industries, for example) are riskier than growth companies. So they should have higher expected returns, and
- Even if small-cap/value outperformance was an inefficiency and it has been eliminated, there’s no reason think that a portfolio tilted toward small-cap or value stocks would perform any worse in the future than a “total market” portfolio.
Why I Don’t Overweight Small-Cap or Value Stocks
So why, despite the evidence showing that, historically, “tilting” one’s asset allocation slightly toward small-cap and/or value stocks has tended to increase returns somewhat without a corresponding increase in portfolio volatility, do I not overweight small-cap or value in my own portfolio?
To answer that question, we first need to back up a step and discuss a general asset allocation principle.
Asset Allocation 101: Stick with the Plan
The specific asset allocation plan you choose is often less important than your ability to stick with it. (This is part of why it’s important to assess your risk tolerance before blindly allocating your entire portfolio to stocks in an attempt to earn higher returns.)
By definition, a small-cap/value-tilted portfolio will have some periods in which it underperforms a “total market” portfolio and some periods in which it outperforms. This is known as “tracking error,” and it isn’t necessarily a bad thing.
If, however, you’re somebody who would start to doubt your choice–and potentially back out on it at the worst time–during a period of relative underperformance, you should think twice about implementing a tilted portfolio.
And that’s the boat I’m in. For whatever reason, I’ve come to have a strong suspicion of anything remotely clever when it comes to investing. Usually, when somebody promises higher expected returns without an increase in risk, they’re full of baloney.
And so, when it comes to overweighting small-cap/value stocks, I see the benefit now, when looking at it from a detached point of view. But I’m not at all sure how confident I’d be if it were my actual money at stake and my (tilted) portfolio had just underperformed a “total market” portfolio for the last several years.
Instead, I stick with a portfolio that I have a more intuitive grasp of: a tiny, tiny slice of the world economy, plus a smattering of bonds.
In short, I choose a portfolio that (depending on who you ask) may be slightly inferior, but the implementation of which I’m more confident I won’t mess up.