August 22, 2011 By Rick Ferri

Small company stocks with value characteristics help you achieve your investment objectives by increasing portfolio returns and lowering risk.  So says many noted academics, including Eugene Fama and Ken French, as well as Zugang Liu, Ph.D. Assistant Professor at Penn State University, who has a new study titled Time, Risk and Investment Styles .

Fama and French quantified small cap and value stock risk and return using a three-factor model. Professor Liu looked at the risks and returns of small cap and value stocks to determine which style investors should choose if they went all in that style.

Liu’s study found that a small-cap value style was the safest over long investment horizons for both conservative and more aggressive investors. It was also one of the top equity styles for short-term investing. In contrast, small cap growth stocks were the most risky style across all investment horizons for both types of investors.

I’m not an advocate of going all in with small cap value stocks as Professor Liu advocates because the short-term volatility can be huge. Rather, I believe in a balanced approach. My strategy is a mix of two-thirds in a total stock market index fund and one-third in a small cap value index fund.

Figure 1 illustrates how the two-third total market and one-third small value performed over a 30 year period using Russell indexes. The upper-right is the risk and return of the small cap Russell 2000 value index and the lowest point is the Russell 3000 broad market index. The left axis is the annualized 30 year return and the bottom is portfolio risk as measured by annual standard deviation.

There are also nine portfolios on the “efficient frontier” curve. Each marker represents the addition of 10 percent shifts from the R3000 to the R2000SV index. Portfolios were rebalanced annually. The efficient frontier helps us visualize where the most efficient allocation sat during the period.

Figure 1: The Efficient Frontier of Small Value and Total Market

I highlighted a point on the efficient frontier representing a portfolio of two-thirds in the R3000 broad market index and one-third in the Russell 2000 small value index. This mix resulted in a risk and return that was very close to the lowest risk of any portfolio. An investor using this mix, rebalanced annually, would have earned an extra one percent return annualized above the R3000 and would have achieved this return with one percent less in risk. You can’t complain about that!

Unfortunately, looking at long-term results is not always productive because it hides short-term volatility. It’s also helpful to break the long-term down into smaller pieces so we can see what happened over non-overlapping periods. Figure 2 illustrates how the two-thirds and one-third strategy worked out over three different decades.

Figure 2: Two-thirds R3000 and One-third R2000V over Three Decades

The three decades had notably different risks and returns. There was no benefit to owning small cap value stocks during the 1980s. In fact, having one-third in the R2000V actually took away return and increased portfolio risk. The decade ending in 2000 did result in a risk reduction benefit but very little return benefit. Finally, the strategy provides a strong return benefit and a slight risk benefit during the decade ending in 2010.

I also ran the number for a 20 year period from 1991 to 2010. The most efficient point on the frontier was a fifty-fifty strategy. Adding a 50 percent position in small cap value stocks increased portfolio returns by more than 2 percent annually while reducing risk by about the same about. It was easily one of the most rewarding periods to diversify into small cap value in the past 100 years.

Here I must give caution: There are many investors and advisors who are structuring portfolios today that are taking a huge overweight position in small cap value stocks. Many are 50 percent and higher. They’re doing this, in part, based on what happened over the past 20 years.

If you take away one point from this analysis, it should be that small cap value investing requires a long-term commitment. If you’re prone to frustration when the stock market surges and your portfolio is left behind, don’t take heavy small cap value risk.

If you truly understand the extra risk in small cap value, and can weather a period when everyone is celebrating while you’re not, then a one-third position in small cap value investing can be very rewarding.