This blog is the third in a four-part series on factors of return. The first two blogs, Evaluating Factors of Expected Return and A Closer Look at the Market Premium, can be found below.
A review of the historical results of the small premium may help provide you an understanding of long term performance specific to small cap stocks, domestic and international. (The small premium is defined as the incremental return of stocks of companies with low market capitalization over the return of stocks of companies with high market capitalization.)
Over short periods we’ve observed a volatile U.S. small premium. The standard deviation of the U.S. small premium over one-year periods, rolling one month from December 1972 to December 2015, is 12.73%. The graph above helps illustrate the volatility of the small premium over time.
There have been 247 one-year rolling time periods with a negative premium since 1972; however, a positive U.S. small premium occurred 52.22% of the time.
We see similar volatility with the international small premium. The standard deviation of the international small premium over one-year periods, rolling one month from December 1972 to December 2015, is 12.51%. The graph below helps illustrate the volatility of the international small premium over time.
There have been 195 one-year rolling time periods with a negative international small premium since 1972; however, a positive international small premium occurred 62.28% of the time.
We see a less volatile small premium as we extend the rolling periods. The standard deviation of the U.S. small premium decreased to 3.76% over 10-year periods, rolling one month from December 1981 to December 2015. The standard deviation for the international small premium also declined, down to 4.15% over the same time period. The chart below illustrates the decreased volatility of the premium as we extend the time frame.
Positive 10-year small premiums occurred 48.41% of the time in the U.S. and 84.60% internationally. The U.S. premium percentage was affected by a period of negative rolling 10-year premiums lasting for 198 consecutive months from April 1989 to September 2005. The longest period of sustained negative international small premiums lasted for 59 months from September 1997 to July 2002.
Despite these sustained periods of negative small cap premiums, we do observe positive average 10-year premiums both domestically and internationally. In addition, the U.S. and international rolling 10-year small premiums can waver between positive and negative within the same calendar year, as was the case in 2015 when it varied between positive and negative throughout the year.
As with the market premium, it is important to maintain a long-term perspective when analyzing performance given the volatilty in year-to-year premium performance and the long-term performance of the U.S. and international small premiums.
Past performance does not guarantee future results.
Indexes are unmanaged baskets of securities in which investors cannot directly invest; they do not reflect the payment of advisory fees or other expenses associated with specific investments or the management of an actual portfolio.
All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution.’
The risks associated with investing in stocks and overweighting small company and value stocks potentially include increased volatility (up and down movement in the value of your assets) and loss of principal. International markets involve additional risks, including, but not limited to, currency fluctuation, political instability, foreign taxes, and different methods of accounting and financial reporting. As a result, they may not be suitable investment options for everyone.