A simple asset allocation model for deciding between small and large caps
As mentioned earlier, an observation regarding the large discrepancy between the returns of small and large caps at any given year and that fact that this discrepancy last for several years mean that investors can generate greater returns than just simply buy and hold for more than 20 years. As you shall see in the following illustrations, one just needs to follow two simple steps when deciding to hold either all small or large caps ETFs in the coming year.
The stated asset allocation model is based on a single assumption.
As will be expected from historical data and the causations behind, trends favouring either small or large caps will continue for at least a few years most of the time.
As a consequence of the above, there is only one simple rule to follow when doing asset allocation between small and large caps, which is to cash out from current holdings in small or large caps and invest in either one that returned more in the preceding year. The challenge now lies in choosing suitable benchmarks and ETFs that tracked them for use in this simple asset allocation exercise between small and large caps. The first step in implementing this asset allocation model is to choose a suitable benchmark to represent both the small and large caps respectively. There are two factors to consider for choosing the best benchmark for doing this asset allocation exercise. The first is that it is best or even essential that the indexes contain almost all the listed small and large caps stocks listed on the various stock exchanges as the fundamental reasons for the large differences in return between small and large caps is due to four reasons affecting their earnings in various economic climates. Indexes like the Dow Jones Industrial Average and S&P500 are definitely not a good representative of the whole large caps stocks due to their relatively small numbers of large caps include compared to how much large caps there are in the whole country. After which is choosing the index that has the longest history. Finally, still needs to choose a suitable ETF that track the index chosen from among many others.
When the above mentioned steps have been done, the next is to analyze historical results and see whether historical data conforms to this theory for the case of your country. For the sake of illustrations, we will choose the Russell 1000 for large caps and Russell 2000 for small caps. With these two indexes or benchmarks in mind, then take the following steps to decide which market caps stocks to invest in.
1. For simplicity, we will use the last day of the calendar year, as in last trading day of the calendar year to ascertain the total returns.
2. There are only two possibilities, either the small or large caps returned more, which to invest in for the coming year will depends on which one return more for the preceding year. For instance, if small caps returned more at the end of the year, then continue staying invested in small caps or switched to small caps for the coming next year if hold large caps currently.
We can analyze the results from past returns data, compare and contrast two investing strategies, having a fixed asset allocation and holds small and large caps all the way, that is buy and hold for a really very long term versus a slightly more active method but still not active to the extent of spending your life watching stock tickers of basing investment decisions on which market caps returned more during the year at the end of the year. That is if you observe, will give significantly higher returns than just simply buy and hold.
Translating into physical actions by implementing the above asset allocation plan with ETFs,
There are some slight differences between the returns of indexes and the ETFs that tracked them, returns from market indexes do not consider tax effects and distributions from capital gains when the ETF involved needs to sell a stock when the company is removed from its index, though it does includes dividends and that capital gains distributions are relatively minor. In addition, see that ETFs historical and current price information can be easily obtained from Yahoo Finance or other similar websites. Do take note that ETFs returns will match pretty close to but still less than their underlying indexes since there is this expense ratio, though still much smaller than actively managed mutual funds.
In conclusion, the reason behind this asset allocation is to increase returns significantly relative to just buy and hold a fixed percentage of asset allocation between small and large caps for decades, without corresponding increase in risk. Another crucial point to take note is that in any statistical game of chance, one still needs to stay in the game long enough to reap its rewards, even if the odds is in your flavor. In this case, as you can find out for yourself, by following the above two steps or strategy, you will be correct around 70% of the time, from historical data, a pretty high success rate. But to be correct 70% of the time, one needs to follow the strategy consistently through the decades. But since past performance is not guarantee of future results and if you are a high net worth individual, there is no need to do this asset allocation using 100% of funds intended to invest in equities. Like if worth more than $10 million and got $5 million invested in stocks, can use $1 million or less for this particular asset allocation model.
Related posts:
