In this article we outline several important facets of historical market performance. This has great relevance to investors who are looking to make successful decisions about how to over or underweight their portfolio positions to maximize performance over the long term.

Asset Class Premia and Investment Returns

An asset class premium is how investors are compensated for the risk they take by investing in certain types of assets. There are several important lessons about this that we can learn from the chart below.

Small cap stocks have outperformed large cap stocks over long periods of time in the US, Developed ex US (International) Markets and Emerging (International) Markets. Among investment professionals this is known as the “size premium.”
You can also see that value stocks have outperformed growth stocks over long periods of time. This is known as the “relative price premium” or “value premium.”
The chart shows that high profitability stocks have outperformed low profitability stocks which is known as the “profitability premium.”

Looking at the above graph makes things look easy. In order to increase your returns, it seems as if all you would have to do is overweight small companies to large companies, value companies to growth companies and high profitability companies to low profitability companies. This would have been the case over these long periods of time -- but unfortunately over shorter periods of time, as we will see, this is not always true.

Dimensions of Expected Returns from 2010 -2019

The chart below shows us the returns for small vs large, value vs growth and high profitability vs low profitability over the last 10 years.

As you can see over the last 10 years in the US, small cap stocks underperformed large cap stocks and value stocks underperformed growth stocks. In international markets, smaller companies did outperform larger ones but value stocks underperformed growth stocks.

What are the lessons for investors to be learned here?

1. Even though small cap, value and high profitability stocks have shown long term outperformance over the decades, you should never invest only in these types of stocks at the exclusion of large cap, growth, and lower profitability stocks.

2. Overweighting to these areas of the market may be a prudent strategy, but it needs to be balanced so returns are still good even when these areas of the market do not outperform.

Because we expect there to be long periods of underperformance for small, value and high profitability companies, it’s important to go about investing in an objective, patient way. Discipline will be required if you decide to overweight small, value and high profitability companies because of these extended periods of underperformance. Be careful not to change your strategy at just the wrong time.

The next graph will illustrate how quickly performance numbers can change.

While stock returns are unpredictable, there is precedent for the value premium turning around quickly after periods of sustained underperformance. For example, some of the weakest periods for value stocks when compared to growth stocks have been followed by some of the strongest (see Exhibit 2). On March 31, 2000, growth stocks had outperformed value stocks in the US over the prior year, prior five years, prior 10 years, and prior 15 years. As of March 31, 2001 – one year and one market swing later – value stocks had regained the advantage over every one of those periods.

Stay Positioned for The Long Term

The theoretical support for value investing is longstanding – paying a lower price means a higher expected return. However, realized returns are volatile. A 10-year negative premium for value investing is not what we would ordinarily expect, but it is not unusual either. The same holds true for small cap stock investing.

Yet history illustrates that changing course after a disappointing spell for known premiums can lead to missed opportunities. When those drivers of outperformance have turned around in the past, steadfast investors have been rewarded.

A key to successful long-term investing is sticking with your approach, even through difficult periods, so that you are there for the good times, too.

Reference: Historical Performance of Premiums over Rolling Periods

The graphs that follow show you how often the various premiums have outperformed over 1, 5, and 10-year periods for US and International markets. For example, the “Market beat T-Bills” shows you how often a US Total Stock Market Index has historically outperformed a guaranteed Treasury Bill Index.

If you would like to see additional details on a year by year basis of the premium’s performance, contact us and we will send you the year by year data.