The only two stock funds you’ll ever need

Then I’ll show you how to get a lot of that benefit in a way that’s probably much more comfortable.

Almost certainly you will want to add one or more fixed-income funds, but that’s a topic for another day. This discussion is about the equity part of your portfolio.

Read: As Dow sinks over 1,000 points, signs of panic-selling emerge in the stock market

The very highest returns

Based on data from 1970 through 2021 – a total of 52 years – two of the most productive asset classes have been U.S. large-cap value stocks and U.S. small-cap value stocks.

Over that period, a 50/50 combination of those two asset classes had a compound annual growth rate of 14.1%; meanwhile the S&P 500
SPX,
-0.34%
by itself grew at 11.1%. Over that long time frame, $10,000 grew to $2.3 million in the S&P 500, vs. nearly $9.5 million in the two-fund all-value combination.

In the 1970s, when the S&P 500 grew at only 5.8%, the all-value combo grew at 13%. While the S&P 500 struggled through two tough bear markets between 2000 and 2009, losing 0.9% annually, the all-value combination had a compound growth rate of 8.4%.

However, 50-some years is a very long time. I get it.

We calculated the returns for every 15-year period from 1928 through 2021. Of all 80 of those periods, the average compound return for the S&P 500 was 10.7%. The average return for large-cap value was 12.8%; for small-cap value it was 15.6%. When we computed the numbers for average 40-year periods, the results were similar.

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Of course I can’t tell you about future returns, but there’s every reason to believe that in the long run, value stocks are likely to continue to outperform the S&P 500.

Based on everything I know, the way to make the most money without speculating or gambling is in U.S. value stocks. A great way to do that is a 50/50 combination of small-cap value and large-cap value.

High returns with more comfort

However, I suspect most investors will balk at that recommendation. Value stocks, after all, don’t have the sizzle of big growth stocks like Microsoft
MSFT,
-0.21%,
Apple
AAPL,
+1.31%,
Amazon
AMZN,
-0.71%,
Facebook
FB,
-0.26%,
and Tesla
TSLA,
-0.39%.

Most investors don’t want their returns to be too different from “the stock market,” which in the popular press is commonly represented by the S&P 500.

Over the long term, some of the best returns in U.S. stocks come from a relatively small number of large growth companies like those that dominate the S&P 500…and from small-cap value stocks, as we saw above.

These are two very different asset classes. The S&P 500 isn’t for bargain hunters: Stocks in the index sell for about $20 for every dollar of current profits. Small-cap value is a bargain hunter’s mecca, with stocks going for about $12 for every dollar of current profits.  

So here’s a multimillion-dollar idea for you: Invest the equity part of your portfolio in a combination of those two asset classes: small-cap value stocks
AVUV,
-0.60%
and the S&P 500.

From 1970 through 2021, a portfolio equally split between the S&P 500 and small-cap value stocks would have compounded at 12.7% and experienced nine losing calendar years. For the S&P 500 alone, the compound return was 11.1%, with 10 losing years.

That difference of 1.6 percentage points might not seem enormous. But over a lifetime, a difference of just 0.5% can be worth more than $1 million in retirement distributions plus what’s left to leave to your heirs.

So I’m not kidding when I say this is a multimillion-dollar idea.

If small-cap value stocks intrigue you with their returns and yet they still feel a bit scary…you can allocate less than half of your equity portfolio to them.

We calculated annualized returns and other data for combinations of the S&P 500 and small-cap value stocks to show various results, all the way from dipping your toes in the water with just 10% in small-cap value to a much more aggressive posture with 90% in small-cap value. The data is for 1970 through 2021.

Over these many years, each additional increment of small-cap value added 0.2 to 0.4 percentage points to the long-term return. Over a lifetime, each additional 10% in small-cap value could be worth hundreds of thousands of dollars.

Many people tell me they are skeptical of value stocks these days. The reason isn’t hard to come by: recent performance. From 2010 through 2021, the S&P 500 grew at 15.1%, and small-cap value stocks at “only” 12.1%. 

If relatively short-term recent performance is your preferred guide to the future, you don’t need the lessons of history.

However, if you’re willing to look a little deeper, here are two interesting comparisons:

·      In the 25 years from 1975 through 1999, the S&P 500 had a compound annual growth rate of 17.2%. Meanwhile, an index of small-cap value stocks grew at 22.3%.

·      From 2000 through 2021, the S&P 500 compounded at 7.5%, small-cap value stocks at 10.8%.

So why are small-cap value stocks so productive? Primarily because they are cheap to buy.

One of the most quoted rules of investing is “buy low, sell high.” Small-cap value stocks are the way to do that.

Yes, it feels uncomfortable. But if you buy value stocks by the hundreds or thousands, as you can easily do in mutual funds and ETFs, that’s where the money is likely to be made.

For decades, I’ve preached diversification based on long-term track records of asset classes that are relatively well understood. Both the S&P 500 and U.S. small-cap value stocks certainly qualify.

I also preach moderation. That’s why I think some combination of the S&P 500 and small-cap value stocks is likely to be a winner for the equity part of your portfolio.

For more on this topic, here’s a podcast I recorded.

Richard Buck contributed to this article.

Paul Merriman and Richard Buck are the authors of We’re Talking Millions! 12 Simple Ways to Supercharge Your Retirement. Get your free copy.