In the course of meeting with potential clients, we often come across investment portfolios that are ill suited to achieve the individual or family’s goals.  Many accounts are littered with a random amalgamation of individual stocks or high-cost actively managed funds that were bought (or sold to them) based on past performance.  Others are mostly concentrated in basic index funds like the S&P 500 or Total Stock Indexes which are heavily focused on the biggest blue-chip companies.

Even before we are hired and set about creating a customized asset allocation that is designed to achieve their unique objectives, we are able to illustrate a few simple and immediate ways these folks can improve their portfolios.  Here we will focus our attention on the US-stock segment of their allocations:

STEP 1: Diversify Across Large and Small Stocks

Currently, Total Stock Indexes have around 90% in large and medium-sized stocks, with only about 10% in small cap stocks, so they are anything but “total.”  Small cap stocks not only have had higher historical, as well as future-expected returns, but they’ve also provided helpful diversification as large and small companies don’t always move in unison.  Table 1 below shows that, from 1975-2013, splitting the US-stock allocation of a diversified portfolio 60% into large cap stocks and 40% into small cap stocks and rebalancing annually has resulted in over 1% per year higher returns when compared to a traditional index fund, with only a slight increase in volatility.  This return also came without much “tracking error” relative to the market’s return, meaning its outperformance didn’t result in significant short-term differences in return compared to the market index (i.e. the two portfolios tracked each other fairly closely).

STEP 2: Separate Stocks By Value and Profitability

Total Stock Indexes, as well as standard large cap or small cap indexes (to a lesser extent) weight stocks based on their price and therefore tend to overweight the companies that have had the highest recent returns and by extension the lowest future-expected returns.  This would be fine, except that most of these “cap-weighted”  indexes are underrepresented in the lowest-priced value stocks as well as the most-profitable growth stocks, which both have higher-than-market expected returns.  What’s more, these opposite sides of the market (value and growth) also tend to move up and down at different periods of time.  Further splitting our 60/40 portfolio above into equal halves “low-priced value” and “highly-profitable growth” indexes and rebalancing annually, the Diversified Asset Class Index in Table 1 has increased historical returns by almost 4% per year over the market with slightly less volatility than the simple large cap/small cap index mix.  What’s more, there was hardly any additional market “tracking error” for this portfolio compared to the simple large/small index, and it resulted in the highest “tracking error premium.”

STEP 3: Consider An All-Value Approach If You Dare

While both low-priced value stocks and highly-profitable growth stocks have historically generated higher-than-market returns, the clear winner over the last four decades between the two has been value.  And the smaller the value stocks the better.  So for investors with a strong stomach and tolerance for a portfolio that looks very different from the market in terms of return and risk over the short run, flipping the large/small split to 40/60 and using only value-stock asset classes for both has added another 2% in returns over the more diversified asset class index when rebalanced annually.  As we’d expect when we decrease diversification (by eliminating the growth asset classes), the volatility of the All-Value Asset Class Index goes up as well by almost 3%, a significant jump when compared to the leap from the US Total Stock Index to the Diversified Asset Class Index.

And volatility alone doesn’t tell the whole story here.  Despite considerable long-term historical outperformance, during the short-term periods from 1984-1990, 1995-1999, and 2007-2008, the all-value mix underperformed the market by -3.1%, -7.3%, and -8% per year !  Of course, the diversified asset class mix also trailed the market, but by a much more palatable -1.8%, -4%, and -2.6% per year.  This is “tracking error” on display, of which the all-value approach had twice the amount of the more diversified asset class portfolio and is therefore less “efficient” when looked at in terms of how much excess market return you’ve earned versus how different the performance has been compared to the market return.

TABLE 1. Historical Risk and Return of Various Index Portfolios (1975-2013*)