When investing, should you chase performance or diversification?
Charles Sims Jr., Special to The New Tri-State Defender | 3/31/2017, 10:44 a.m.
In 2013, the S&P 500 index, generally considered representative of the U.S. stock market as a whole, produced total returns of 32.39 percent — the highest return for the index since 1997. But the S&P 600, which represents the stocks of smaller companies, returned 41.31 percent.
Consider a hypothetical investor named Jim, who looked at those returns at the end of 2013 and decided to sell his shares in an S&P 500 index fund and reinvest them in an S&P 600 fund, hoping to ride the hot stocks of smaller companies. Index mutual funds and exchange-traded funds (ETFs) attempt to track the performance of a benchmark index by holding the securities that comprise the index; individuals cannot invest directly in an unmanaged index.
The trade would have been a disappointment for Jim. Small-cap stocks slumped in 2014, with the S&P 600 returning just 5.76 percent. By contrast, the S&P 500 returned 13.69 percent. Jim would have missed out on the higher return because he tried to chase prior-year performance. If he continued to chase performance and switched his investments back to an S&P 500 index fund, he would have been slightly ahead in 2015, a down year for the market in general, and then lost out again in 2016 when small caps again outpaced large-cap stocks (see chart).
Spreading the risk
This example clearly illustrates the danger of chasing performance, but it also demonstrates why owning stocks in companies of different sizes can be a helpful diversification strategy. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.
Companies are typically classified based on market capitalization, which is calculated by multiplying the number of outstanding shares by the price per share. There is no standard classification system, but Standard & Poor’s indexes offer a helpful comparison and are used as benchmarks for many funds.3
S&P 500 (market capitalization exceeding $5.3 billion). Stocks of larger companies, or large caps, are generally considered more stable than those of smaller companies. Large caps may provide solid long-term returns and possibly higher short-term returns in some years, as they did in 2013. But large caps typically have lower growth potential because they have already experienced substantial growth to reach their current size.
S&P MidCap 400 (market capitalization of $1.4 billion to $5.9 billion). Mid caps may have greater growth potential than large caps, and mid-sized companies can sometimes react more nimbly to changes in the business environment. Mid caps are associated with greater risk and volatility than large caps, but are considered less volatile and risky than small caps. Although they may not be the best performer in any given year, mid caps have produced the highest returns over the last 10-, 20-, and 30-year periods.4
S&P SmallCap 600 (market capitalization of $400 million to $1.8 billion). Small-cap stocks might offer the highest growth potential of the three classifications, because they have the furthest to grow and are more likely to react quickly to market opportunities. However, they are typically the most risky and volatile class of stocks, as illustrated by the performance swings of the last four years.
The performance of an unmanaged index is not indicative of the performance of any specific security. Past performance is not a guarantee of future results, and actual results will vary. The investment return and principal value of stocks, mutual funds, and ETFs fluctuate with market conditions. Shares, when sold, may be worth more or less than their original cost. Supply and demand for ETF shares may cause them to trade at a premium or a discount relative to the value of the underlying shares.
(Charles Sims Jr., CMFC, LUTCF, is President/CEO of The Sims Financial Group. Contact him at 901-682-2410 or visit www.SimsFinancialGroup.com).