Investors snooze while small stocks soar

Despite small-cap stocks nearing their all-time high, investors still seem to be jumping ship on the asset class.

Since early October, the Russell 2000, a benchmark index for small-cap stock performance, has risen about 36 percent. At the end of last week, the index stood just 4.2 percent below the record high set in April. Yet many investors weren't around to see the rise. Since the end of April, small-cap mutual funds have seen $15.9 billion in outflows, and small-cap exchange-traded funds (ETFs) have seen $4.4 billion fly out the door.

Most likely this is due to the underperformance in small-cap stocks. The small-cap premium -- or the difference between the returns of small-cap and large-cap stocks -- was -8.5 in April through September. While large-cap stocks were outperforming, investors yanked assets out of small-cap mutual funds in 37 of the 40 weeks since May.

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Driving forward while looking in the rearview mirror inevitably will lead to a crash. Similarly, investing based on yesterday's returns will cause you to buy after bull markets (at high prices) and then sell after bear markets (at low prices). That's obviously not a good strategy -- yet it's the one employed by the majority of investors. This shows up in the studies comparing the returns that investors earn with the returns of the funds in which they invest. Invariably, in aggregate, the behavior of individual investors creates what Carl Richards called the "behavior gap" -- investor returns are well below investment returns.

There's a simple, although not easy, way to avoid being part of that crowd. The answer is to have a well-defined investment plan and stick to it. And that means not just buying and holding -- but buying, holding and rebalancing as required. Rebalancing forces you to buy the assets that have done relatively poorly (at lower prices) and sell those that have done relatively well (at higher prices). It's simple -- but not easy -- as emotions like fear and panic overcome the wisdom of this elegant, profitable approach.

[moneywatcherz]

Are they currently under, over, or fairly valued?

Is it beneficial to delay moving into classes within one's AA when they are over valued?

[maynardGkeynes]

Larry, thanks for your cordial reply. However, you seem almost to be suggesting that institutional investors employ a passive investment strategy. I do not believe this to be the case. They are quite active, which I believe you have qualms about yourself. If your point is that small investors tend to chase performance, which is not smart, I agree. If you are suggesting that the disinvestment by retail investors in small caps reflects performance chasing (or the inverse, in this case), I don't see how you can support that case, unless you are more certain than I that things will work out just ducky for small caps in the future. Having read your excellent work, I doubt that you would make that claim. Basically, we all know that the small caps have been among the chief beneficiaries of the massive risk on trade that almost purely liquidity driven. The risks to investors are huge (it's basically a huge macro bet), and I think that retail investors recognize that. That is a respectable view, which has merely proved less lucrative than an opposite strategy so far. Whatever it is, I don't see how you can ascribe it to performance chasing, or a failure to stick to a plan. Perhaps the plan was wrong. Regardless, thanks always for your thoughtful advice to small investors, which has proved very valuable to me through the years. I just don't get this one. BTW, I am in small caps to a significant extent, but i see them as very risky, and not a good place for most small investors.

[LarryswedroeCBS]

Maynard
You are mixing two issues with institutional investors. First, about 40% of their assets are passively invested. That is large percent, about 3x that of individual investors. Second, even those that use ACTIVE managers often have passive asset allocation strategies, rebalancing on regular basis. So in that way they act like passive investors.

Then we had last year as a negative year for small cap premium, and retail investors do what they persistently do, SELL after they go down, or do relatively poorly. Consider that after market bottom in March of 09, over 300b of retail money fled mutual funds missing the greatest bull market in over 70 years.
Very persistent behavior. Note the story is supported by many academic papers including those from behavioralist Brad Barber and Terrance Odean and others by the Bogle Financial Center and Morningstar among others, all showing that the returns earned by individual investors are well below the returns of the very funds they invest in, and the stocks they buy go on to UNDERPERFORM after purchase and the ones they sell go on to OUTPERFORM after sale. Note same is true for men, women and even investment clubs.
Sad but true, investors see their worst enemy when they look in the mirror.

Best wishes
Larry

[maynardGkeynes]

So Larry, if mutual fund investors are pulling out of small caps, who are geniuses bidding up the prices? 2%/20% hedge funds, meaning heads they win, tails their pension fund/endowments/Greenwich Village country club clients lose? Leveraged Wall St, banks playing with the taxpayers money? Why should small investors want any part of that? Personally, I think retail investors are being pretty smart right now. They know who the mark is, and its them.

[LarryswedroeCBS]

The institutional investors. Retail investors almost always get it wrong because they buy AFTER periods of high performance when things then look safe, and returns are expected to be low, by definition, and sell AFTER periods of poor performance when things look risky and by definition expected returns are high.
For example after March 2009 bottom they pulled out over $300b during greatest bull market in over 70 years, when market doubled.
Instead institutions tend to adhere to plans, simply rebalancing, and that causes them to buy after periods of weak performance (low) when expected returns are high and sell after periods of strong performance when prices are high and expected returns are low.
That is also what smart individual investors do. Have an asset allocation plan and adhere to it, ignoring the noise of the market and not allowing emotions to get in way.
This has nothing to do with hedge funds or Greenwich Village. Hedge funds by the way also persistently underperform (mostly because of high fees and high turnover). But investment discipline, which individuals don't have.
Retail investors don't have to be the mark, but they have to learn how to invest the right way. Good way to start learning is read this blog regularly and read my books (:-)) Might start with Wise Investing Made Simple

Best wishes
Larry