Small Cap Indexes and Diversification question

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PeterParker
Posts: 137
Joined: Sun Mar 17, 2013 2:19 pm

Small Cap Indexes and Diversification question

Post by PeterParker »

Hello everyone--

Second post here--

I just paid down my student loan debts -- all of them. Hooray, debt free! :D

I'm also 25 and don't have a mortgage yet.

Anyway, I wanted to wade into the market here. I have a comfortable emergency fund that I'm going to move into a 1% savings account soon.


I wanted to start with about $3,000 and add more as time goes on (probably about $1000 a month perhaps).

I read the philosophy here and Total Market funds seem to be the best idea for someone who isn't extremely sophisticated or savvy with market trends. I plan to throw money into an index fund and leave it there basically for decades or longer.

I HAVE noticed, however, that Small Cap Index funds tend to outperform the Total Market funds fairly consistently --- at seemingly every interval. Perhaps they have greater variance and swing up and down more --- but for a long-term hold strategy, why wouldn't one put it all into a Small Cap Index?

It comprises of so many stocks and industries to be sufficiently diversified, in my opinion.

Diversification is only to manage variance --- but variance matters less and less in the long term, doesn't it?

IE, take investing in the Total US, vs. total International, vs Total World (or blend).

The Total World or a blend is obvious the most 'diversified" of the three choices.

But what that means, essentially, is that it's a weighted average of Total US and Total Intl. You are basically average the two, and since they are generally not correlated, it's likely they both won't do something crazy simultaneously --- reducing variance, so to speak.

Like it or not, however, that weighted average is basically your prediction on how the markets will perform in comparison. If you have the slightest idea that the US or Intl will perform better long term, mathematically, you should put 100% of your funds into that asset -- provided you have no care or concern about variance on the way.

I know, it's a simple concept --- your allocations theoretically trade maximum returns for reduced variance. If you truly have no idea which will perform better (I sure as hell don't), then a split allocation will average the same returns, but with reduced risk.

Anyway, it seems somewhat obvious to me that Small Caps Indices DO outperform the total market --- it seems logical to put 100% of investments in here provided one is confident in the "outperform" statement.

I can see why variance in a handful of stocks can be a big problem --- especially since those seem to be much more uncertain "gambles." But the additional variance of a small cap index vs total market? It doesn't seem a problem --- hell, casinos don't carry about the variance at their slot machines. They know over time, they're coming out ahead.

You can't use the same certainty with stocks, but eh.


Anywho.... I was thinking about putting my initial $3,000 in NAESX -- the Vanguard Small Cap Blend Index (I didn't find a major historical difference between value, growth, and blend --- a least nothing that wasn't mental masturbation).

It's not the admiral shares but it seems to outperform the Schwab small index SWSSX even with expense ratios factored in.

If I read right, this has no buying fee--- no early redemption fee (Schwab has 2%) --- no anything fee except the expense ratio. And the $20 yearly fee is waved if you sign up for electronic statements.

Well, as a sort of complete newb who's ready to take the plunge --- am I missing anything here? I know "variance" definitely has to be mitigated as one approaches retirement --- but I think even 10 years is a time period with sufficiently low variance overall.

I frankly don't see why anyone should invest in bonds at all until age 30, or even older. IF you are confident stocks will outperform bonds in the time frame, or by any future date. If cash flow and your assets at any given time or important, then sure.
BYUvol
Posts: 120
Joined: Sat Mar 24, 2012 3:06 pm
Location: KY

Re: Small Cap Indexes and Diversification question

Post by BYUvol »

What you have is a great strategy, until it isn't.
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BrandonBogle
Posts: 3787
Joined: Mon Jan 28, 2013 11:19 pm

Re: Small Cap Indexes and Diversification question

Post by BrandonBogle »

Honestly, first I'd start with saying you should be investing in an IRA (pick your flavor). Second, invest it all in a Target Retiremet or Lifestrategy fund. When you have gone a year or two and built up 10k, then reevaluate tweaking your allocations. And since you bought in an IRA, there is no cost to sell the existing fund and invest in whatever you choose, even if it totally in Small Cap Index. But at least during this time you got your feet wet with minimized risk.
Topic Author
PeterParker
Posts: 137
Joined: Sun Mar 17, 2013 2:19 pm

Re: Small Cap Indexes and Diversification question

Post by PeterParker »

What you have is a great strategy, until it isn't.
I'm not saying I "figured out" the stock market, even remotely --- but I don't think this is a crackpot Martingale system.

Many people here generally advocate a Total Market index fund. Or even international exposure for maximum diversification (+ bonds allocation, of course).

I'm aware hardly anyone, if anyone, can say they can predict the market with any certainty.

But the Small Cap Index has outperformed the Total Market YTD, 1 year, 3 year, 5 year, and 10 year.

Even with greater variance involved --- I don't see a downside. And I think unless you're approaching retirement and NEED to prevent a dip in your assets (even the 2008 dip -- and the Great Depression -- were temporary) --- you should go for the long-term haul.
FillorKill
Posts: 1007
Joined: Sat Aug 06, 2011 7:01 am

Re: Small Cap Indexes and Diversification question

Post by FillorKill »

Read Benoit Mandelbrot.

Recommendation #1: The (mis)Behavior of markets - A fractal view of risk, ruin and reward authored by Mandelbrot and Hudson.

Here's a prelude:

http://users.math.yale.edu/~bbm3/web_pd ... relude.pdf
Default User BR
Posts: 7501
Joined: Mon Dec 17, 2007 7:32 pm

Re: Small Cap Indexes and Diversification question

Post by Default User BR »

I don't think it's a horrible plan. Historically, small-cap has outperformed. It's probably a risk-based outperformance, so there's no free lunch. Many of us here tilt towards small to a degree, although usually not that much. My Morningstar style box for domestic looks like:

16 18 11 | 45
05 06 03 | 14
18 15 08 | 41
__ __ __
39 39 22


Brian
MKP
Posts: 222
Joined: Sun Jun 26, 2011 7:56 pm

Re: Small Cap Indexes and Diversification question

Post by MKP »

Default User BR wrote:I don't think it's a horrible plan. Historically, small-cap has outperformed. It's probably a risk-based outperformance, so there's no free lunch. Many of us here tilt towards small to a degree, although usually not that much. My Morningstar style box for domestic looks like:

16 18 11 | 45
05 06 03 | 14
18 15 08 | 41
__ __ __
39 39 22


Brian
Heh-mine is similar. I am working toward 40% small cap.

Code: Select all


18 17 17  I  52
06 06 04  I  16
15 11 06  I  32
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39 34  27
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