A dramatic example of the potential for underperformance is the five-year period ending in 1999. Small value stocks underperformed the S&P 500 by 13.8 percentage points in that period. The S&P returned 28.6 percent, while the Fama-French small value stocks, ex-utilities, returned 14.8 percent. The longest period when small value stocks underperformed the S&P 500 was the 19-year period from 1984-2002.
Such periods create risk for investors falling prey to the dreaded disease known as “tracking error regret.” Investors abandon their well-thought-out, long-term plans because their portfolio has underperformed some popular market index, such as the S&P 500.
While small value stocks have exhibited a high degree of persistent outperformance, there’s certainly no guarantee they will do so in the future, no matter how long your investment horizon. Any asset class can underperform for long periods.
If you doubt this, just consider folks who invested in Japanese equities, who have experienced negative returns of 1.9 percent a year for the period from January 1990 through December 2013. But if you’re not prepared to experience very long periods of underperformance, you shouldn’t invest. That’s true whether we’re talking about stocks or bonds in general, or any individual asset class.
One of my favorite expressions is that diversification is the only free lunch in investing. So you might as well eat as much of it as you can. But to enjoy the benefits of diversification, you must be patient. Otherwise, you’re likely to catch that tracking-error disease and abandon your plan. It’s those stop-and-start approaches to investing that doom most investors to poor returns. They own stocks but end up with bondlike returns.
While my own personal portfolio—which the New York Times referred to as the “Larry Portfolio”—holds almost exclusively small value stocks, you shouldn’t consider it, or anything close to it, unless you are a highly disciplined investor who doesn’t confuse strategy and outcome, and is thus willing to stay the course through good and bad times. Being forewarned is forearmed.
Larry Swedroe is the director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.