My commentary two weeks ago on the myth of the “election cycle theory” generated many questions from our clients; all along the lines of “what about the (insert your hypothesis here) theory?” The two most common “theories” asked about were the Super Bowl theory and the small company stock effect. Let’s explore these two ideas.
The Super Bowl effect started to become popular during the 1970’s, when a few arm chair quarterbacks who were also arm chair investment analysts noticed that whenever one of the teams from the original National Football League won the Super Bowl, the market tended to go up (and when they lost, the market tended to decline). Indeed, this Super Bowl theory worked
for 28 out of the first 31 years. However, over the past 14 years, the Super Bowl theory has worked only 7 times; exactly what pure randomness would suggest. Sorry for the buzz kill.
A more seriously believed “theory” is the small capitalization stock effect. Around the same time the Super Bowl effect was first being discussed, serious academic researchers were discovering that over the previous 50 years, small cap stocks outperformed large cap stocks. Various reasons were proposed about why that occurred, and many investment managers began concentrating on small cap stocks (today Morningstar has classified over 2000 mutual funds as having a small
While it’s not surprising that a silly idea like the Super Bowl effect would have no validity as an investment approach, surely a well-researched, logically-based theory like the small-cap stock effect would produce enhanced returns … wouldn’t it?
Unfortunately, most investors would have done better using the Super Bowl effect than the small cap effect. The Frank Russell Company began calculating indexes of small company stocks in 1984 – their Russell 2000 is the most widely-used index of small company stock performance. Between 1984 and 2011, the average annual return of the Russell 2000 was 8.7%, compared to the return of the S&P 500 of 10.2%. The annual standard deviations of the Russell 2000 and S&P
500 were 20% and 16%, respectively, so the “enhancement” of small cap stocks was in the risk, not in the return.
Why didn’t small cap stocks outperform large caps over the last 28 years? There are many possible explanations, but the most likely is that the research available on small cap stocks’ performance, which was not widely known in the 1970s, has become well known since, and such knowledge has evened the playing field and removed any advantage. Regardless of the reasons, it seems clear that the small cap effect has not improved investors’ returns over the past three decades.
The biggest problem with the small cap myth is that so many people (some of them being investment advisors) base their investment decisions on assuming its true. For example, the American Association of Individual Investors (a group that typically provides solid investment guidance) publishes recommended asset allocation models, in which it suggests that aggressive investors put as much money in small company stocks as in large company stocks. An investor who invested $100,000 in an all-large-company stock portfolio in January, 1984 would have $1.6 million by December, 2011, while an investor who “enhanced” their portfolio by investing half in large cap and half in small cap would have only $1.4 million ($200,000 less), with much more periodic volatility (based on the returns of the S&P 500 and Russell 2000 indexes).
Does this mean investors should avoid small cap stocks entirely? Absolutely not – we recommend modest allocations to small company stocks for most of our clients, because a small allocation will help diversify most portfolios. But it’s important to make investment decisions based on current market data, and not on research using solely results that are 30 years old.