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Why does one portfolio do better than another in a given year? The answer: Over 95% of your return as an investor is dependent upon the asset classes you own. For example: In 1998 the market rewarded domestic large cap growth (think S&P 500) with a return of over 42% while in the same year domestic small cap value was down over 6 percent! That's a huge (48%+) difference for owning one domestic stock asset class versus another in the SAME YEAR!
So what is the "best" asset class to own over time? An excellent question! Academics Eugene Fama (a Nobel Prize winner in economics) and Ken French extensive research on the history of stock returns answered that question. Their research on the subject describes "Risk Factors" which return the most for investors and answers the question of why owning mostly large, domestic companies is NOT in your best interest:
#1) Risk Factor: Stocks vs. Bonds
While far more volatile, stocks on average do much better than investing in bonds. The "premium" or average amount that stocks outperform is a little over 8 percent per year since 1928.
#2) Risk Factor: Small vs. Large Stocks
Small companies have a greater amount of uncertainty than do large companies. That uncertainty means that investors require a higher return to compensate for owning smaller companies. Since 1928, smaller companies have generated over two percent in average excess returns versus large companies in the US.
#3) Risk Factor: Value vs. Growth
Value is just another way of saying comparatively cheap. Growth is just another way of saying comparatively expensive. Growth companies are companies that investors are willing to pay a higher price for because the investors believe they will grow more. Since 1928, the average excess returns for owning value is over 3.5 percent per year compared to owning growth stocks!
#4) Risk Factor: High vs. Low Profitability
Important Caveat:
Popularity changes quickly. The advantages of owning large, domestic companies in 1998 changed very quickly in subsequent years. A portfolio weighted to risk factors has produced consistently better results in the past and will continue to in the future. Ultimately, only patient and well-educated investors stands to reap these rewards...
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