“A Man’s inability to see the power of regression to the mean leaves him blind to the nature of the world around him.”
Michael Lewis, The Undoing Project: A Friendship That Changed Our Minds.
Reviewing historical annual long-term equity premiums and returns, we can conclude the following:
- US Small companies outperform US Large Companies by 2.02%
- International Small companies outperform International Large companies by 4.91%
- US Value companies outperform US Growth companies by 3.18%
- International Value companies outperform International Growth companies by 4.66%, and
- Emerging Value companies outperform Emerging Growth companies by 5.10%
Note, however, that these premiums are not realized each year, and indeed quite the opposite can occur for extended periods (5-10 years). In recent the years, this has been the case.
US Large companies, commonly represented by the S&P 500 Index, have recently outperform most other equity asset classes. This recency bias, fueled by media hype and misinformation, has tempted many investors into believing more exposure to the S&P 500 is warranted.
However, a simple review of “The Lost Decade” of 2000-2009 where the S&P 500 suffered through a -0.95% annualized returns while other asset classes enjoyed returns as high as 13.46% reminds us that chasing one single asset class would not be advisable. This period reconfirmed the principle and importance of proper diversification among various keep asset classes.
We only have to extend our period a big longer from 2000-2019 to see these long term averages take shape which show Value and Small companies outperforming US Large Growth (S&P 500).
A look at Q4 2020 asset class returns may be signaling a regression to asset class long term means, highlighted in the Dimensions of Expected Returns data above, as Small Caps and Value Companies outperformed the S&P 500 (US Large Growth).
There are trends away from long term means, and there are regressions to the long term means. Is this simply a short term trend or a regression?
The disciplined long term investor understands long term expected dimensions of returns and is not lured by short term trends.