Using a Chimp to Improve Your Returns

If you're like me, you spend too much time following the New York Yankees, you find it hilarious that professor Jeremy Siegel was asked about his sex life in his most recent investment book (more on that below), and your wife is perpetually mad at you for your inability to put your clothes away properly. And by "properly" I mean nothing more complicated than "not on the floor, OK?"

But another trait you'd share, were you to find yourself in the mostly unfortunate circumstance of being like me, is an absolute fascination with the market returns calculator on that wonderful site moneychimp.com.

There, you'll find a lot of nifty articles and tools for both beginner and advanced investors. The Building Portfolios page, in particular, has a special place in my heart. It includes an intoxicating calculator that breaks down the market returns for the total stock market by large and small cap, value, and growth for any time period you'd like to check out between 1927 and 2003.

Say, for instance, that it becomes absolutely pressing for you to know how segments of the market performed during the life of Douglas Adams, the author best known for the hilarious Hitchhiker's Guide to the Galaxy five-book trilogy. Adams lived from 1952 to 2001, which, if we start at the beginning of 1952 and go through to the end of 2001, happens to provide a nice round 50 years of history. Plugging those dates into the moneychimp.com calculator, we discover the following:

Add about 4% to those figures for inflation over the time period, and you'll get the "nominal" returns of the stock market, which may look more familiar to you. Here, let's set that out:

The question that immediately pops into mind upon reading this is, "Well, why not just invest only in small-cap value stocks?"

Well, one of the answers to that, and a very good one, is the volatility inherent in investing in small caps. If you go a little further down the moneychimp.com page, you'll see that you can play with various portfolio asset allocations, with a handy default allocation provided of 90% total stock market and 10% small-cap value stocks.

In that case, your nominal total stock market portfolio returns over the Douglas Adams lifetime horizon would move up from 11.65% to 12.30% and the standard deviation (a typical measure of risk) would stay nearly the same. Over 50 years, $1,000 would compound to $247,136.20 at 11.65% annually but to $330,360.27 at 12.3%. So that seemingly small advantage over time becomes very significant.

If you were to have held a portfolio of all small-cap value stocks, however, your returns would have improved significantly but your standard deviation also would have shot up to 23.96% from 17.07%. In case standard deviation figures aren't ones you normally process in your head, note these Motley Fool Hidden Gems stocks and how they've moved one day after they announced earnings in the past week:

While the stocks picked so far in Motley Fool Hidden Gems are beating the market, with returns of 23% vs. the market's less than 4% over the same two-year period, the volatility demonstrated above explains in part why a portfolio completely handed over to small caps is not generally recommended. This brings us back to the default asset allocation that moneychimp.com provides -- 90% of your portfolio devoted to a total stock market index fund and 10% to small-cap value stocks.

This is not a bad allocation for those thinking of stepping away from a total stock market index fund as their target allocation and taking on slightly more risk with the odds in their favor of getting better returns.

Siegel's constant
The small addition of some small-cap exposure might be thought of as an attempt to escape what is becoming known as "Siegel's constant." Siegel's research shows that the average real return of stocks is between 6.5% and 7.0% over virtually any long time period you care to measure, starting in 1802 and up through 2003. Adams' life span actually just beats that range, but extend his life no more than one more year (oh, but he deserved so much more than that!), and because of the poor returns in 2002 you get total stock market real returns of 6.76% -- smack dab in the middle of Siegel's constant.

Investors, of course, are often willing to take on more risk in the pursuit of better returns, but a classic mistake is to make too much of a more limited time period than, say, 50 years in determining how to do that. Between 1995 and 1999, large-cap growth stocks broke through their historical trend and easily outdistanced the rest of the market, producing nominal 31.24% annual returns over that five-year period. This near-term rearview mirror analysis made a lot of investors passionate about the superiority of large-cap growth stocks.

Siegel dedicates large chunks of The Future for Investors to showing how growth stocks get overvalued in the large-cap arena. He recounts how, on April 19, 1999, he took to the pages of The Wall Street Journal with an article titled "Are Internet Stocks Overvalued? Are They Ever." Citing data for the 25 years after the 1972 peak of the Nifty Fifty era, Siegel demonstrated how growth tech stocks such as IBM (NYSE:IBM) purchased in 1972 and held had underperformed the market. He contrasted that with value consumer brand Nifty Fifty stocks such as Coca-Cola (NYSE:KO) and Pfizer (NYSE:PFE), which continued to beat the market over the 25 years starting in 1972. The article argued that at a price in 1999 of over 700 times earnings, AOL, now part of Time Warner (NYSE:TWX), was likely -- highly likely -- to underperform the market. It was, as you're no doubt aware, a pretty good call.

No good deed goes unpunished, however. So Siegel was rewarded with any number of predictable emails, one of which he hilariously quotes. It concludes, "By the way, when was the last time you got laid? You're a party pooper. Thanks a lot, jerk. I suggest you go to the StreetAdvisor.com to read about why you're so wrong, idiot. Do you even know how to get to a website, you child?" It's comforting to know that it isn't just online writers but big-shot professors as well who get these kinds of well wishes.

Siegel was right about the price of Internet stocks in particular, and large-cap growth in general has been no picnic since that time, producing flat returns from the beginning of 1999 through the end of 2004, while small-cap value has produced nearly 20% nominal annual returns in the interim.

History shows a few things, though. While this recent total domination by small-cap value will at some point revert to the mean, investors over the long term can be significantly rewarded by having some small-cap exposure in their portfolios without adding unnecessary risk.

If you'd like to pick small-cap stocks for your portfolio, Motley Fool Hidden Gems has some ideas for how to do it. You can sign up for a free, no-obligation trial today.

Bill Barker owns no shares in companies mentioned here. The Fool has a disclosure policy.