Comparing the Five Major Categories of Stocks

A quick note before I begin today’s commentary. The Internal Revenue Service updated its guidance regarding the CARES Act. I haven’t read the full notice yet, but I do know there are revisions affecting required minimum distributions (RMDs). RMDs taken this year—including in January—can now be rolled over to an IRA by August 31, 2020. In addition, rollovers of RMDs do not count against the one rollover per 12-month rule. On a separate note, we corrected the calculation of average one-year low and high returns discussed in last week’s commentary.

Over the long term, equities have realized the highest returns of the major asset classes. Stocks provide growth of wealth. The price for this growth is volatility, particularly downward price moves. (No one seems to mind volatility when it pushes prices upward.)

There are a few ways to manage this volatility. One is to adjust how much portfolio exposure you have to stocks. We’ll get to this in a couple of weeks when I introduce the next worksheets for The AAII Way. Another is to diversify among different categories of stocks.

At the end of this week’s commentary, you’ll find tables with historical returns for five well-followed indexes: S&P 500 index, S&P MidCap 400 index, Russell 2000 index, MSCI EAFE index and MSCI Emerging Market index. We also show additional data to provide insights on volatility and how a blend of all five has worked. But first, a few insights and observations about each index.

The S&P 500 is the most widely followed index. It tracks the performance of the largest U.S. companies. These companies are considered to be more fundamentally sound and many have international operations. They are also more likely to pay dividends than their smaller domestic brethren. The S&P 500’s strong relative performance over the last 10 years makes it easy to forget that the same index fell in value between 2000 and 2009 (aka, the lost decade).

The S&P MidCap 400 tracks mid-sized companies. Being neither large nor small, the stocks in this index are often overlooked in terms of allocation discussions. Yet, mid-cap stocks have outperformed both their large- and small-cap brethren over the last 20 years. This outperformance has been accompanied by volatility similar to the S&P 500. Notably, the S&P MidCap 400 has had the highest calendar-year return just one time over the past 20 years, in 2000. This fact demonstrates how diversification can increase your odds of being allocated to the right type of stocks at the right time.

The Russell 2000 targets small-cap companies, specifically those whose market capitalization ranks them between 1,000 and 3,000 in terms of size based on the criteria used by FTSE Russell. Because these companies are smaller, they are less likely to pay dividends, more likely to be domestically focused and are more volatile. Since analysts pay less attention to them and large institutional investors can’t allocate much money to them, small-cap stocks are more likely to be mispriced and thus have higher upside potential. However, the long-term outperformance of these stocks (aka, the small-cap premium) has not been realized over the last 10 years.

The MSCI EAFE is the most widely followed international index. It tracks large- and mid-cap stocks in more than 20 developed market countries located in Europe, Australia, Asia and the Far East. As of May 2020, Japan, the U.K., France and Switzerland accounted for 60% of the index’s country weightings. Foreign markets often don’t move in lockstep with the U.S. markets, thereby providing a diversification benefit. (Correlations tend to rise during turbulent market conditions, however, making these less of a diversifier relative to other asset classes, like bonds.) Currency fluctuations will also affect the returns realized by U.S. investors. Unfortunately, the diversification benefits have been offset by lackluster returns over the last 20 years.

The MSCI Emerging Markets tracks companies from 26 different countries across the globe. China has a major influence on the index’s returns with a 33% country weighting. This is more than double the weighting of the second-most represented country, South Korea. The argument for emerging markets is their economic growth potential. Still young economies, volatile currencies and, often, political issues (unstable governments, rogue leaders, corruption, etc.) are risks. As such, these stocks are not for the faint of heart as can be seen by their high levels of volatility. While emerging market stocks enjoyed a high level of relative performance during 2000–2009, they were also the worst-performing category over the past 10 years.

The aggressive allocation mix shown in the tables below reflects the stock portion of our aggressive allocation model (which will be discussed in a future Investor Update). It calls splitting the equity allocation into two-thirds domestic stocks and one-third international stocks. All indexes are weighted evenly except for emerging markets, which gets a half weighting (approximately 11% of the equity portion instead of 22%).

While our aggressive allocation mix of equities has underperformed the S&P 500 and the S&P MidCap 400 indexes over the last 20 years, the argument for diversifying it is that we don’t know which of the five indexes will perform best over the next 20 years. If we had a working crystal ball, it would be easy to pick one index or category of stocks. We don’t, and neither does anybody else. Spreading investment dollars over different types of stocks increases the odds of being allocated to the right category at the right time.

Data on all five indexes and our aggressive allocation mix of equities is shown below. The first two tables provide return information. The green shaded cells highlight the best-performing index for a given period. The last table provides data on how volatile each index has been. Next week, I’ll provide similar data on bonds.