From Jonathan Edwards: “It’s a fundamental tenet of investing that, over time, small cap stocks outperform large cap stocks. One might be tempted, then, to invest in small cap-oriented mutual funds. But it’s not clear whether the studies that demonstrate the superiority of small caps assume that you hold them once they become big caps or sell them and invest in other small caps. If you bought Microsoft in 1986 and held it, you did well. But a small cap mutual fund that bought Microsoft in 1986 has presumably long since sold it since it doesn’t meet their small cap investment guidelines. Do you (or your correspondents) have any idea whether one can follow the small-cap-mutual-fund path to riches?”

One of my correspondents, Less Antman, does indeed have a very clear view. He writes:

“The belief that small stocks outperform large ones may be more of a fundamental myth than a fundamental tenet of investing. The academic studies were incredibly flawed, failing to take into account the enormous spreads between bid and ask prices on lightly traded stocks and the historically high trading costs. All of them assumed that investors repeatedly traded in the smallest stocks without incurring ANY trading costs whatsoever, turned over their portfolio at blazing speed, and paid no income taxes back in the days when tax-sheltered brokerage accounts didn’t exist. David Dreman’s recent revision of Contrarian Investment Strategies [yours for $17.50 from www.amazon.com or $15.75 from www.booksamillion.com] did an excellent job of identifying the bogus nature of the ‘small stock advantage.'”

In the real world, Less notes, small stock mutual funds have a consistently inferior historical record to large stock mutual funds, primarily because of higher management and trading expenses. (In the investment horse race, the mutual fund with the lightest jockey – the lowest expenses – has a huge advantage.)

“The traditional 2% advantage of small stocks over large stocks disappeared in 1982,” Less continues, “not surprisingly the year that Ibbotson Associates [a respected arbiter of such things] switched from artificial indexes of small stocks to the actual results achieved by the DFA 9-10 stock index fund (it invests in the stocks with market capitalizations in the ninth and tenth deciles, meaning the smallest 20% of market capitalization). The DFA fund underperforms the index it was intended to duplicate – the one that beats big cap stocks by 2% – by approximately, SURPRISE!, 2% per year.

“Finding a terrific little company with a product you believe in and then holding on for years could make you rich, but habits of savings, diversification, and patience during bear markets are much more likely to help you achieve your goals. Small stocks can be a good diversification tool, since small and large stocks don’t perform in identical fashion, but there is no magic in small stocks. Buy and hold stocks, or buy and hold mutual funds, and you’ll do well. Short Amazon because you’re smarter than Mr. Market, and you’ll be forced to write daily commentaries to pay your food bills.”

Ouch.

 

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