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Achieving Higher Returns with Small Companies

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This video shows investors how they can improve their portfolio’s performance by owning small cap stocks.

Achieving Bigger Returns with Small Companies

So what are your options for achieving higher returns in your investment portfolio?

You may have heard the saying, “Higher risk equals higher return”.  However, in the world of investing not all risks are worth taking.  Simply, because not all risks compensate investors with higher returns.  For example, if you played football without a helmet you would certainly be taking on more risk but that doesn’t mean you’re going to score more touchdowns.  Every day investors take on what’s called, “uncompensated” risks, which are risks that do not compensate you with higher returns.  The most common risks involve holding concentrated positions in individual stocks, or betting on a single industry sector or single country, to outperform the market.

So what type of risks have been shown to “compensate” investors with higher returns?

In our last video, Asset Class Investing, we discussed how diversifying across multiple asset classes can smooth out the bumps in your portfolio’s performance.   In this session we’re going to show you how you can increase your portfolio’s performance, without speculating, by structuring your portfolio around what’s called “compensated risks”, which are risks worth taking because they pay you higher returns.  To do this, let’s revisit the four primary asset class groups from our video “Asset Class Investing”:  Large Cap Growth, Large Cap Value, Small Cap Growth, and Small Cap Value.

If I were to ask you which group of companies are riskier, large companies or small companies?  You would probably select small companies, and you’d be right.

Small companies are inherently risker because they are not as established as large companies.  As a result, their access to capital is more costly as investors and lenders expect a higher return for taking on higher risk.  Therefore, small companies must produce higher returns or else why would you invest in them if you could get the same return from a larger company that’s safer?

To demonstrate this point, let’s take a look at the average annual return of US Small Cap companies vs. US Large Cap companies as far back as data exist, which is 1927.  Over this complete time period through 2012, US Large Cap companies have produced an average rate of return of 9.4% annually – not too bad.  However, US Small Cap companies, over the same time period, have produced an average annual return of 11.3%, nearly 2% per year higher. Keep in mind, this is not just a handful of small companies, but rather all publicly traded small companies that exist.

Now if what I’m saying is true, then this Small Cap return premium should not just be limited to companies in the US. The same risk factor should exist for small companies outside the US. How about companies in International Developed Markets, such as Japan, Australia, Germany, France, and the United Kingdom to name a few.  Well, there’s also data on these companies that goes back as far as 1975, nearly forty years, that shows International Large Cap companies returned on average 11.0% annually, while International Small Cap companies returned, over the same period 14.8% annually. This shows that the Small Cap return premium exists globally.  If this is the case, then we should also see similar results in the Emerging Markets countries like China, Brazil, India, and others. Here we have data going back to 1989, which shows that Emerging Market Large companies returned on average 12.3% annually, while Small Cap companies in the Emerging Markets returned 13.5%.

So what does this mean to you? Well, there’s good news and bad news.  The good news is that you can increase your portfolio’s expected return, without speculating, by simply owning small cap companies in the US, International, and Emerging Markets.  The bad news is that most 401k plans may only offer US Small Cap as a fund choice.   If your plan does offer International and Emerging Market fund options they are most likely only Large Cap funds.  This is where having access to a self-directed brokerage account in your retirement plan will benefit you; by allowing you to purchase low-cost ETFs (exchange-traded funds) that invest specifically in indexes that track US, International, and Emerging Market Small Cap companies.

For information on the benefits of using a self-directed brokerage account in your retirement plan, and the benefits of ETFs, you can view these videos at RetirementInvestor.com.

In the meantime, remember, if its bigger returns you’re seeking, Small Cap companies are a risk worth taking!

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