A Difficult Year

2011 was a difficult year for people using our approach to investing, which involves broad global diversification with an emphasis on small cap and value stocks. None of that worked out very well in 2011. International developed markets were down 15% and emerging markets dropped 21%. Things were better in the U.S. where the S&P 500 finished about even. However, the S&P 500 is a large cap index; small cap and value stocks showed losses in 2011, both in the U.S. and abroad.

So is this cause for concern? Well, nobody likes to have a bad year, but what we saw in 2011 is not unexpected. You never know which asset class will shine in a given year. Investing solely in the U.S. stock market would have worked out well last year, but avoiding international stocks is a poor strategy over the long run. As shown below, international stocks, both in developed economies and emerging markets, have outperformed the U.S. market over long time periods:

Also shown in the above table is the fact that small cap and value stocks have historically outperformed large cap and growth stocks, respectively, and by substantial margins. However, earning these higher returns requires a long-term perspective because, in a given year, anything can happen. Since 1927, small cap U.S. stocks have outperformed large cap stocks in 46 years and underperformed them in 38 years. Over the same time period, U.S. value stocks have outperformed growth stocks in 52 years and underperformed in 32 years. 2011 just happened to be one of those years when small cap and value stocks both underperformed.

Typically, investors are rewarded in proportion to the risk they take. Many economists believe small cap and value stocks outperform over long time periods because the market rationally discounts their prices to reflect underlying risk. The lower prices give investors greater upside as compensation for bearing this risk. The academic finance literature refers to the higher returns provided by small cap and value stocks as “risk premia.” The only way to capture these risk premia (i.e., higher returns) is to invest for the long run and ride out the years, like 2011, that prove to be difficult for small cap and value investors. Having the patience and discipline to stick to a sound financial strategy through good years and bad gives you the best chance for long-term investing success.

As always, please feel free to contact me with questions or comments.

Jeffrey J. Brown, MD CFA
Principal, Shearwater Capital

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