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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.

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