Most stock market investors lost money last year, and the greatest part of that was in the first three quarters. Then things turned around. The fourth quarter of 2011 was positive, and last quarter was downright (or should I say upright) amazing. As a portfolio manager (that's the hat I'm wearing when I'm not wearing the financial planner hat), I got a few questions from clients about their accounts, and one was, "Why am I doing worse than the benchmark?" during the down times and, "Why are we doing better than the benchmark?" in the last two quarters.
It's All About The Tilt
The answer has everything to do with the core-and-tilt strategy I use to build portfolios.
I begin with a "core" holding. It's always a mutual fund and usually it's a broadly diversified equity index fund like the Vanguard Total Stock Index or the DFA Core Equity Fund. If I'm working inside a 401(k) plan where my choices are more limited, I may choose a different fund but it's always a large cap blend fund. In any case, these funds own large, well-established companies that are the staples of the economy.
Next, I add one to three funds (depending on the size of the portfolio) to give it a "tilt" toward small cap stocks (little companies) and/or value stocks (cheap companies). For example, I might use the Vanguard Small Cap Index, the DFA Large Cap Value Fund, or if I want to get both the small cap and value exposure in one fund, I might use the DFA Small Cap Value Fund. (In smaller accounts, I may use only one fund that has core and tilt built in, which saves transaction costs and taxes.)
Studies have shown that over longer periods of time (think decades) small cap stocks and value stocks have outperformed large, well-established companies. This phenomenon has come to be known as the "value effect" and the "small cap" effect.
Small cap and value stock funds are riskier than core funds, so they tend to lose value faster in declining markets and gain value faster in rising markets. So during times like the first three quarters of last year when the broad market was down, our portfolios performed worse than the benchmarks, and when the markets recovered, our portfolios did better.
Over the very long haul, I expect that stocks will continue to be volatile but they will continue to gain value (otherwise I wouldn't invest, and neither would you, right?). I also expect the small cap and value effects to continue, so the tilt should help us do a little better than average.
If you want the specifics about how to build a core-and-tilt portfolio, or if you have a question about your portfolio, give me a call at 541-463-0899. You might also enjoy these articles about how to build a core portfolio, the small cap effect, and the value effect.