One of the most common nicknames for your retirement portfolio is "nest egg," but in the realm of food metaphors, it might be better to think of it like a holiday feast. So many dishes, so many choices, and to be healthy, you need to pick a properly balanced meal -- but also one that suits your personal tastes. So how should one do that? The answer comes under the heading of "portfolio allocation," and it's the focus of this episode of Motley Fool Answers.
In this segment, hosts Alison Southwick and Robert Brokamp talk about the asset class that is their favorite side dish: small-cap U.S. stocks. Their performance makes it worth getting a heaping helping. They also talk about micro-caps -- sweet when they pay off, but risky. And to continue with the carbs theme, they briefly dig into mid-cap stocks -- the stuffing of the meal. In other words, a delicious and profitable asset class that tends to get forgotten. Neither as volatile as small caps, nor as stolid as the average blue chip, there have been many periods when they've outperformed both.
A full transcript follows the video.
This video was recorded on Nov. 20, 2018.
Robert Brokamp: Now let's move on to the next item on our Thanksgiving investment menu -- potatoes! Likely of the mashed variety. What are the potatoes of your portfolio? I say U.S. small caps. And while the phrase small potatoes usually denotes something of little consequence, the historical returns of small-cap stocks are, well, spud-tacular.
Since 1926, U.S. small-cap stocks have returned 12.1% a year, so about 2% more a year than large caps. The best year was 143%. The worst year was down 58%. Now this Morningstar Target-Date Report didn't break out small caps, specifically. Instead they grouped small caps and mid caps together, what many people call SMID.
Alison Southwick: SMID!
Brokamp: There you go! But by looking at the allocations of some of the biggest target-date funds, I could see that roughly speaking, for most of these funds, when you look at the SMID category a quarter of it is actually small. So, again, looking at the broad category of target-date funds and what some of the biggest firms think how you should invest, they have about 18-19% in SMIDs, which means about 5% in small caps and that's just 5% of your stock allocation.
I think that's way too small. Especially if you are a moderate to more-aggressive investor, it's perfectly fine to have at least 20% of your stock allocation in small caps and maybe as much as your large-cap allocation.
Now, when I talk potatoes in your portfolio, I'm talking about the standard white variety, but I know there are some people who like the sweet potatoes mush with the marshmallows on top for Thanksgiving.
Southwick: Not this girl, but all right. Let's talk about it!
Brokamp: When it comes to your portfolio, the sweet potato mush could be microcaps. Those are the smallest of the small. We're talking companies that are worth $250 million and maybe up to $500 million. When you look at the long span of history, they actually have performed the best of any asset class; like 14% a year.
The problem is they're crazily volatile and also because they're so small they can often be illiquid, which makes them difficult to buy. In fact, if you look at some of the microcap index funds [and there are only a few], they have trouble matching the index because it's difficult to buy and sell some of the stocks that are actually in the index. In my model portfolios in Rule Your Retirement, only those who are more than 10 years from retirement have an explicit allocation to microcaps. For those who are closer to retirement, I don't have that specific allocation because they're so volatile.
So you don't need them, just like you don't need the sweet potato whatever, or as some people call them, yams.
Southwick: I'm not going to miss them on my plate.
Brokamp: You're not going to miss the microcaps.
Southwick: So I've got turkey. I've got some white mashed potatoes. What's next?
Brokamp: I mentioned the mid caps and I'm going to give a specific allocation to mid caps and I'm going to say it's the stuffing.
Southwick: I do love stuffing!
Brokamp: Or the dressing depending on where you live. Generally speaking, to folks in the North it's stuffing and to folks in the South it's dressing. And I chose mid caps to be the stuffing because just as stuffing is something that people usually forget about during the non-holiday time of the year, people don't usually think of mid caps. It's like the ignored asset category, especially when you're looking at the size of companies.
Southwick: But stuffing's so good!
Brokamp: The stuffing is really good!
Southwick: It's so good!
Brokamp: So if you look at the long-term history [like since 1926], mid caps performed just about right in the middle between large and small. But there are long periods when mid caps outperformed both. For example, since 1993 mid caps have outperformed large caps and small caps, so it's not something to ignore in your portfolio. I think you could start again with what the target-date report has -- an allocation of about 15% of your stock allocation. I think you could easily bump that up to 20-25% as to how much you should own in mid caps.