The superior returns of small stocks requires some amount of faith. Even though statistics show small stocks outperform large stocks in the long run, that is, since 1926, the market hasn't provided corroborating evidence in the years since Rolf W. Banz discovered the anomaly in the efficient market hypothesis in 1981.
In his new book on long-term investing, Jeremy J. Siegel, professor of finance at the Wharton School, University of Pennsylvania, points out the danger to investors of relying on such long-run returns without analyzing them.
From 1926 through 1992, the latest year he uses in his book, small stocks, as represented by the index composed by Dimensional Fund Advisors Inc., outperformed large stocks, as represented by the Standard & Poor's 500 Stock Index, achieving over the period a cumulative premium of more than 200%.
But as Mr. Siegel points out, take away the nine-year period from 1975 through 1983 - when small stocks had a great run over large stocks - and the small stock premium disappears. In fact, the total return on small stocks falls nearly 25% below the total return for large stocks for the period from 1926 through 1992 when that nine-year period is eliminated from the data.
Interpreting the data, Mr. Siegel cautions, "Even for the long-term investor, it is clear that if you don't catch the small-stock wave, you miss the boat." Nonetheless, he concludes small stocks belong as part of an investor's portfolio. But he warns, "(T)he superior performance of small stocks is quite dependent on the period analyzed."
His analysis of the small-stock phenomenon comprises only a small fraction of his book - "Stocks for the Long Run: A guide for selecting markets for long-term growth," published by Richard D. Irwin Inc., Burr Ridge, Ill. Its 334 pages contain a wealth of insight into long-term investing and professional money management. In investing, it concludes, as the title suggests, that in the long term, stocks are the superior investment to bonds or shorter-term fixed income securities. In money management, he warns about the underperformance of most managers, the harm of advisory fees and transaction costs to total return over the long term and the need to carefully select and monitor investment advisers.
In international investing, Mr. Siegel notes even considering the war that devastated the economies of Japan, Germany and the United Kingdom, stocks demonstrated their ability to not only rise in value but record superior performance to fixed-income instruments.
In fact, he points out the cumulative real, or inflation-adjusted, returns on German, U.K. and U.S. stocks from 1926 through 1992 are within a percentage point of each other. (He leaves Japan out of this particular comparison, although he provides elsewhere data showing Japanese stocks have exhibited similar superiority in returns, especially after World War II.)
His conclusion favoring stocks reinforces what many in the pension investment community have been teaching for years. In fact, Mr. Siegel credits Edgar L. Smith's 1924 study showing the superior performance of stocks over bonds. But in the wake of the 1929 stock market crash and Depression of the 1930s, he notes, such wisdom was largely ignored, despite the evidence of the data, until it was revived in 1964 by the famous study of Lawrence Fisher and James H. Lorie and finally popularized in 1976 with the more expanded study by Roger G. Ibbotson and Rex A. Sinquefield.
"It took nearly a generation for most investors to gather enough courage to re-enter the stock market after the great stock collapse" of 1929, he writes. That's unfortunate.
No one has yet to produce any similar string of studies making a compelling case for bonds on either a risk-adjusted, or inflation-adjusted basis. Mr. Siegel shows that in the long run fixed-income securities in general carry more risk, while producing less return than stocks.