Some great terminology arises out of the turmoil of financial markets -- starting with "dead cat bounce" -- a brief uptick in an otherwise falling market. "Where are the customers' yachts" is a reference to the fact that brokers all have yachts, but at the expense of their customers. And so on. ...
More to the point is 1770s era economist Adam Smith's word craftsmanship when he coined the term "invisible hand" to describe the way free markets allow individuals to pursue their own interests which, thanks to an unintended consequence, improve society as a whole.
Yet another term is the so-called "risk premium," which explains why investments involving more risk, in the aggregate, generate higher returns over time than those involving less risk. A small, risky startup, or an established small company with a new successful product can quickly increase in size by several multiples --- making its investors very rich.
It's the invisible hand that can herd long-term investors toward higher yielding, more volatile investments. While self-interest is not so invisible in many people, the push from the invisible hand of market forces creates the incentive for anyone who subjects their money to risk.
All of which leads us to one of the purest expressions of the risk premium -- mutual funds that invest in small companies. Taking the long view, from 1926 to 2014 or almost 90 years, small company stocks earned an annualized return of about 5 percent per year greater than the largest 10 percent of U.S. companies. More recently, the numbers continue to be compelling over the past 20 years -- a risk premium of about 2 percent per year generated by small companies. Investors who could handle some sleepless nights earned close to 12 percent versus 10 percent from the 50 largest U.S. corporations.
Two percent compounded amounts to about 25 percent more money in just 20 years, based on, for example, some steady annual contributions into a retirement plan. Applied to a single lump sum like a grandchild's 529 plan for educational expenses, the additional 2 percent creates about 50 percent more money in 20 years. That 20-year time frame is long enough to wash out much of the volatility and capture most of the 2 percent.
Just to illustrate how unpredictable the returns can be in small company funds, we can look at a one-year period ending earlier in the summer before those August doldrums kicked in. The category earned an average of about 8 percent -- less than half of the 17 percent that large company stock funds generated. Since then, however, the most recent year ending in September shows that the best-performing funds were so-called "micro-cap" strategies investing in the smallest of the publicly traded companies. In one example, the one-year return has been 9 percent in a fund whose 10-year average has been 12 percent. By comparison, the 500 index has generated one-year returns of 5 percent and the 10-year number is about 8 percent.
So that example shows our risk premium doing its job. Until people get to within about 10 years of retirement, there's always a little room in a portfolio for some small cap funds for diversification. In 2000, while the market cratered, small company funds were up 30 percent -- and repeated that gain for the next three years. At just 10 percent of the whole portfolio, returns of that scale can add 3 percent to the overall return. Meanwhile, all this talk about thinking small now has that tune playing in my head from one of the rides at Disneyland: "It's a Small World After All."