No Show

by Harry Jones

(June 3, 1999) -- Harry Jones didn't file a column this week, strangely enough. We'll hope to hear from him next week and see what's cooking.

Small Cap vs. Large Cap, Round 3

by Jeff Fischer (TMFJeff)

The judges are quietly weighing the evidence as we wait and ponder the outcome of the big bout: will nimble small caps come out the winner, or will the stolid large caps emerge victorious?

The head judge steps to the table. He reaches for the microphone. Here comes the decision:

"Ladies and gentleman! The judges have reached a decision. The judges have concluded that this bout... is a draw. It's a tie decision!"

The crowd boos.

People usually favor a clear winner and a clear loser as opposed to split decisions, ties, shared honors, and other vague determinants of value. However, in this world, things rarely need be a case of "either/or." Instead, things can often be a case of "both."

Both dial-up Internet access and cable access can be strong businesses. Both Amazon and Barnes & Noble can co-exist and grow. Both small cap and large cap index funds are attractive.

"But, which is more attractive?" you ask.

I don't feel comfortable answering that. After poring through what data that I could find, I asked Mona Sharma, the Fool's head research wizard, for help on locating historical data on small cap performance vs. large caps. Well, the data is inconclusive. The Russell 2000, which represents the small-cap world, has gained 16.2% annually, on average, since 1972. That's a very impressive 27-year return that, over most 27-year periods, would top the S&P 500 handily. (The Russell 2000 represents the smallest two-thirds of the 3,000 largest U.S. companies, based on total market capitalization.)

However, when you look at other time periods, and blocks of periods, small caps don't look so bright. In the past ten years ended December 31, 1998, the Russell 2000 has gained only 12.92% annually compared to 19.21% for the S&P 500. And as Fool WilliamLipp pointed out, small caps have only outperformed large caps in a minority of cases when one measures performance over various long-time periods, and the most recent period of outperformance occurred over 20 years ago.

That's a big deal.

But even so, we're not very interested in time periods so much as we're interested in a lifetime. Most of us probably have at least 20 years of investing time ahead of us. The average American is 35 years old, so many investors have much longer than 20 years to invest. So, what interests us most is the total long-term return. There is where we hit snags, though, in hard data. Depending on the precise group of small stocks that are measured, and how they're measured, one can argue that small caps have outperformed large caps since 1926 by about 3% annually (about 11% vs. 14%). This is commonly accepted knowledge; perhaps too accepted! Because if one measures slightly differently (different size stocks, etc), and in various set time periods of 10, 20, or 30 years, one can conclude that in many decades small caps trailed large caps. And even the 1926-to-present results can come under question when looking at various studies.

Hmph. A conundrum.

In the end, though, it all seems to come out in the wash. That's not to abandon the topic through the nearest, easiest exit, but to admit that investing is not a perfect science, and that measurements based on varying numbers and means of measurement are bound to return various and often conflicting data that must be rationalized. Depending on how one defines a small cap (what a small cap index holds) and how one measures time periods (by set decades, or by "all time available"), one gets differing results -- of course. Different studies yield different results and hence different conclusions. The most we can conclude here is that the varying results, if one invests for at least 20 years, tend to lean towards slight outperformance to a similar performance of small caps as compared to large caps when measured over numerous decades (at least two, but usually much more).

So what's an index fund investor to do? Either do nothing, or do something.

Nothing: just continue to invest in the S&P 500. You will track the overall market and you might even beat small-cap funds over your lifetime. Because I don't feel that even 70 years is conclusive data. And life is relatively short. Over some lifetimes, small caps will surely outperform large caps. Over other lifetimes, large caps may edge out small caps.

Or, do something: if you're interested in small caps, buy a small-cap index fund to co-exist with your S&P 500 index fund. If the past 70 years are an indicator, both will handily crush over 80% of managed mutual funds while charging almost zero in fees. If you do come to own both index funds, here's one thought: don't sweat which is doing better and question yourself. ("Should I sell the small cap fund and just own large caps?") The two funds will surely trade leading positions back and forth. Over your lifetime, the performance of each could even prove to be a draw. Neither is likely to harm your performance, though, if the fees are almost nil and if you stay invested during good and bad times to eventually earn the bounty of a long-term return in each fund.

To discuss this topic or any index fund topic, please visit us on the Harry Jones message board.

Fool on!

 Recent Harry Jones Portfolio Headlines
  08/26/99  Is it a Nifty 500? Part II
  08/19/99  Is it a Nifty 500? Part I
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  07/29/99  The Foolishness of Index Funds
Harry Jones Portfolio Archives »  

06/04/99 Close

Stock Change Close SPY +2 5/8 133.22
Day Month Year History HARRY +2.01% 1.84% 4.38% 4.38% S&P: +2.17% 1.99% 8.33% 8.33% NASDAQ: +3.12% 0.32% 13.03% 13.03% Rec'd # Security In At Now Change 1/4/99 16 S&P Depos 127.63 133.22 4.38% Rec'd # Security In At Value Change 1/4/99 16 S&P Depos 2042.00 2131.50 $89.50 CASH $0.00 TOTAL $2131.50 Yesterday Today Change S&P Depos 130.59 133.22 SPY +2 5/8


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