Do Small Cap-Value Stocks add Value in Retirement Portfolios?

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Do Small Cap-Value Stocks add Value in Retirement Portfolios?

By Joe Tomlinson

April 8, 2014

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Research going back to Eugene Fama and Kenneth French in the early 1990s has shown that small-value stocks have produced superior returns. Subsequent debate has centered on whether this superior performance will continue and if investors should tilt portfolios to capture those returns. I’ll examine the historical evidence, incorporate it in retirement examples and discuss the future prospects for small-cap value.

Historical performance

The chart below compares real (after-inflation) performance of small-value stocks, large-capitalization stocks and intermediate-term government bonds in the period 1927-2013. The small-value category was based on the Fama/French U.S. Small Value Research Index data obtained from the Dimensional Fund Advisors Matrix Book. The large-capitalization and government bonds returns data came from the Ibbotson® yearbook.

Historical performance, real returns 1927 – 2013

Small Value Stocks Large Capitalization
Inter-term Gov’t Bonds
Arithmetic Average Return




Standard Deviation




Sharpe Ratio



Sources: Fama/French, Ibbotson®

The chart clearly shows the performance gain for small-cap value, with a 7.2% average return advantage over large-capitalization stocks. However, the volatility of performance, as measured by the standard deviation, is higher. Examination of the data also illustrates the volatility difference – the range of annual returns for small-cap value was -53% to 125%, versus -39% to 54% for large-capitalization stocks. The Sharpe ratio provides a measure of risk-adjusted return by dividing the return (in excess of the risk-free rate, for which I have used the government bond return) by the standard deviation. On this risk-adjusted basis, small-cap value still outperforms large-cap significantly.

Financial planning research

Given the superior risk-adjusted performance of the small-cap value category, clients might disregard the various style-box categories and concentrate all investing in small-cap value – at least for domestic stocks. However, such a strategy might give up too much diversification benefit.

Financial planners have researched the role of the small cap in asset allocation, beginning with a 1997 article by Bill Bengen. His original research on the 4% rule used only large-cap stocks and intermediate-term government bonds, and he later determined that he could improve safe withdrawal rates (SWRs) by adding small-cap stocks to the mix. He used a small-cap category that included both value and growth and, based on historical data from Ibbotson®, showed that SWRs increased from 4.1% to 4.3% by including small-cap stocks. He determined that including 30% small cap in the mix was enough to achieve the 4.3% SWR. Further increases did little to increase the SWR, so he settled on recommending a stock mix that included 30% small cap.

In 2011, planner Rick Ferri focused on the small-cap value category as a part of a total stock allocation and used data from 1981 to 2010. He did an efficient-frontier analysis with returns on the y-axis and standard deviations on the x-axis, which showed that stock portfolios with at least 30% small-cap value produced both higher returns and lower standard deviations than portfolios with less than 30% small-cap value. Above 30% small-cap value there was a tradeoff, as increased small-cap value allocations produced higher returns, but with more volatility as measured by standard deviation.

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