What does Bogle mean in this quote? It seems wrong

[tvanzo]

Apparently he believed there was no increase in returns long term from holding SC? This is clearly wrong even for the time period outside of 73-83. Does he not believe in the basic idea of CAPM? In the quote below, he states that the reuts of SC vs LC have essentially been the same in the last 100 years, outside of 73-83. I take a look at the charts and they tell a completely different story. For example, since 1984, the S&P 400 has nearly doubled the returns of the S&P 500. Little confused on the quote.

“Few investment principles,” he said, “have been as unchallenged as the now-perennial assertion that over the long run, small-cap stocks have outperformed large-cap stocks”. Apart from the period 1973 to 1983, when small-caps comfortably beat large-caps, Bogle pointed out that the two strategies have produced pretty similar results since 1928, and that, over time, the winning streaks enjoyed by each have more or less cancelled each other out.

[watchnerd]

Apparently he believed there was no increase in returns long term from holding SC? This is clearly wrong even for the time period outside of 73-83. Does he not believe in the basic idea of CAPM? In the quote below, he states that the reuts of SC vs LC have essentially been the same in the last 100 years, outside of 73-83. I take a look at the charts and they tell a completely different story. For example, since 1984, the S&P 400 has nearly doubled the returns of the S&P 500. Little confused on the quote.

“Few investment principles,” he said, “have been as unchallenged as the now-perennial assertion that over the long run, small-cap stocks have outperformed large-cap stocks”. Apart from the period 1973 to 1983, when small-caps comfortably beat large-caps, Bogle pointed out that the two strategies have produced pretty similar results since 1928, and that, over time, the winning streaks enjoyed by each have more or less cancelled each other out.

I don't know what data you're looking at, but this is what I see in Portfolio Visualizer.

It shows LC beating SC since 1984:

https://www.portfoliovisualizer.com/bac ... ion2_2=100

[tvanzo]

Apparently he believed there was no increase in returns long term from holding SC? This is clearly wrong even for the time period outside of 73-83. Does he not believe in the basic idea of CAPM? In the quote below, he states that the reuts of SC vs LC have essentially been the same in the last 100 years, outside of 73-83. I take a look at the charts and they tell a completely different story. For example, since 1984, the S&P 400 has nearly doubled the returns of the S&P 500. Little confused on the quote.

“Few investment principles,” he said, “have been as unchallenged as the now-perennial assertion that over the long run, small-cap stocks have outperformed large-cap stocks”. Apart from the period 1973 to 1983, when small-caps comfortably beat large-caps, Bogle pointed out that the two strategies have produced pretty similar results since 1928, and that, over time, the winning streaks enjoyed by each have more or less cancelled each other out.

I don't know what data you're looking at, but this is what I see in Portfolio Visualizer.

It shows LC beating SC since 1984:

https://www.portfoliovisualizer.com/bac ... ion2_2=100

Oh the S&P 600 was created in 1989 it seems. So I am looking since 1989. Compare 600 vs 500 since inception. 600 dominates. I put 89 in your link there, and it shows SC and LC as basically even in that time period. Not sure what indexes they are using. I am comparing the charts directly on Yahoo Finance. A bit confused. Yes, LC have slightly larger DY than SC, but it is only around .3% or so on average it seems, I don't think that can explain the massive difference in returns.

[tvanzo]

Also take a look at this graph: viewtopic.php?t=281359

[NiceUnparticularMan]

At a high level, I'd say Bogle was actually a strong defender of the single-risk model (aka CAPM), and a consistent critic of multi-risk models.

Of course the multi-risk models were motivated from the start by the empirical observation that the single-risk model simply was not doing a good job fitting the observed cross-section of stock returns.

And I do think to the extent Bogle tried to defend the single-risk model by eyeballing charts and claiming as long as you held out various periods and didn't look too close at other periods and such, the single-risk model still fit OK . . . that is not a very compelling way of arguing.

[nisiprius]

Apparently he believed there was no increase in returns long term from holding SC? This is clearly wrong even for the time period outside of 73-83. Does he not believe in the basic idea of CAPM? In the quote below, he states that the reuts of SC vs LC have essentially been the same in the last 100 years, outside of 73-83. I take a look at the charts and they tell a completely different story. For example, since 1984, the S&P 400 has nearly doubled the returns of the S&P 500. Little confused on the quote.

“Few investment principles,” he said, “have been as unchallenged as the now-perennial assertion that over the long run, small-cap stocks have outperformed large-cap stocks”. Apart from the period 1973 to 1983, when small-caps comfortably beat large-caps, Bogle pointed out that the two strategies have produced pretty similar results since 1928, and that, over time, the winning streaks enjoyed by each have more or less cancelled each other out.

I believe you are correct. He did think that.

And I think it's quite possible that he was right. The original 1981 paper that convinced everyone that small-caps had higher risk-adjusted returns had major flaws in the data set. The "factor crowd" continues to insist that there is a small-cap benefit of some kind, but they keep subtly changing what is claimed. For one thing, you have to distinguish between higher raw return and higher risk-adjusted return.

For another thing, more and more, claims for a small-cap benefit, just from being small caps, are morphing into acknowledgement that the size factor by itself is weak-to-nonexistent. The new claims is that it functions as an important flavor enhancer in combination with other factors.

The reason why you're confused about the quote is that there is more than one school of thought, and for whatever reasons you've mostly been exposed to a single school of thought.

[NiceUnparticularMan]

For one thing, you have to distinguish between higher raw return and higher risk-adjusted return.

I think it is worth being clear about this.

The question you have to ask is what risks are you adjusting for?

If you believe in a multi-risk model, let's say risks A, B, and C, then increasing your exposure to risks B and C will increase your expected returns.

If you then adjust those expected returns only for risk A, it will look like you increased your risk-adjusted expected returns.

But all you are doing is failing to account for risks B and C in your risk adjustment.

This doesn't mean it is necessarily a bad idea to increase your exposure to risks B and C. But a lot of avoidable confusion has been caused by people not being clear and precise about whether or not they believe various "factor" premiums are in fact risk premiums, and if so what they mean when they discuss risk-adjusted returns.

[FactualFran]

Apparently he believed there was no increase in returns long term from holding SC? This is clearly wrong even for the time period outside of 73-83. Does he not believe in the basic idea of CAPM? In the quote below, he states that the reuts of SC vs LC have essentially been the same in the last 100 years, outside of 73-83. I take a look at the charts and they tell a completely different story. For example, since 1984, the S&P 400 has nearly doubled the returns of the S&P 500. Little confused on the quote.

“Few investment principles,” he said, “have been as unchallenged as the now-perennial assertion that over the long run, small-cap stocks have outperformed large-cap stocks”. Apart from the period 1973 to 1983, when small-caps comfortably beat large-caps, Bogle pointed out that the two strategies have produced pretty similar results since 1928, and that, over time, the winning streaks enjoyed by each have more or less cancelled each other out.

Without a specific reference for the quote, the context is not known. A reference with a very similar, but not exactly the same, statement is in The Telltale Chart speech that Bogle gave in 2002. The first sentence of the "Large-Cap Stocks vs. Small-Cap Stocks" (page 3) is: "Few investment principles are as unchallenged as the perennial assertion that over the long-run small-cap stocks outperform large-cap stocks."

The next page of the document has charts of the cumulative returns from 1928 of large-cap and small-cap stocks and the following statement.

Virtually the entire small-cap advantage took place during the first 18 years. Then large-cap (14.2% per year) dominates small-cap (11.7%) from 1945 through 1964; small-cap through 1968 (32.0% vs. 11.0%); large-cap through 1973 (2.5% vs. –10.8%). Then small-cap through 1983, large through 1990, and so on. On balance, these to-and-fro reversions have cancelled each other out, and since 1945 the returns of large-cap stocks and small-cap stocks have been virtually identical (12.7% vs. 13.3%). So ask yourself whether the evidence to justify the claim of small-cap superiority isn’t too fragile a foundation on which to base a long-term strategy.

[Ben Mathew]

Does he not believe in the basic idea of CAPM?

CAPM does not say that small cap stocks have a higher expected return than large cap stocks. It says that assets that are more highly correlated to the aggregate market portfolio will have higher expected return than assets that are less correlated to the aggregate market portfolio.

The small cap value premium puzzle is that these assets have done better than what would be implied by their correlation to the aggregative market portfolio, i.e. beyond what CAPM would suggest. Whether that's just pure luck, or pricing inefficiency, or fair premium for some less-apparent risk, is a matter of debate. Looks like Bogle thought it was just pure luck, and we can't rule that out.

[NiceUnparticularMan]

Looks like Bogle thought it was just pure luck, and we can't rule that out.

It depends on what you mean by that.

The cross-section of stock returns is subject to statistical analysis. In many different empirical studies, there have been cross-sectional return observations that were statistically significant. Some of these have then survived out of sample testing.

Given that, it is quite unlikely those observations were the product of "pure luck" in the sense of just being generated by random variations.

What actually explains them is, of course, a very challenging question. As is the related question of how, if at all, we should account for these observations in financial planning.

[Ben Mathew]

Looks like Bogle thought it was just pure luck, and we can't rule that out.

It depends on what you mean by that.

The cross-section of stock returns is subject to statistical analysis. In many different empirical studies, there have been cross-sectional return observations that were statistically significant. Some of these have then survived out of sample testing.

Given that, it is quite unlikely those observations were the product of "pure luck" in the sense of just being generated by random variations.

What actually explains them is, of course, a very challenging question. As is the related question of how, if at all, we should account for these observations in financial planning.

Data dredging can generate false positive results with good statistical significance. There are a lot of people poring over the same data looking for statistically significant findings. So there is still room for the "pure luck" interpretation for many results in finance (as in many other fields).

Out of sample tests raise the bar. But a fraction of false positives in one data set will be false positive again in a different dataset. This is likely especially true for globally connected financial markets. There are only so many companies and so many years. Ruling out luck is hard and will require some judgment calls.

[TheTimeLord]

Apparently he believed there was no increase in returns long term from holding SC? This is clearly wrong even for the time period outside of 73-83. Does he not believe in the basic idea of CAPM? In the quote below, he states that the reuts of SC vs LC have essentially been the same in the last 100 years, outside of 73-83. I take a look at the charts and they tell a completely different story. For example, since 1984, the S&P 400 has nearly doubled the returns of the S&P 500. Little confused on the quote.

“Few investment principles,” he said, “have been as unchallenged as the now-perennial assertion that over the long run, small-cap stocks have outperformed large-cap stocks”. Apart from the period 1973 to 1983, when small-caps comfortably beat large-caps, Bogle pointed out that the two strategies have produced pretty similar results since 1928, and that, over time, the winning streaks enjoyed by each have more or less cancelled each other out.

I don't know what data you're looking at, but this is what I see in Portfolio Visualizer.

It shows LC beating SC since 1984:

https://www.portfoliovisualizer.com/bac ... ion2_2=100

Becomes even more interesting when you add in a Mid-Cap portfolio.

[bikechuck]

I wish that people would be more welcoming to less sophisticated users like me and not speak in tongues. What does CAPM stand for?

[nisiprius]

If the topic is "what did Bogle believe," he believed that the stock market asset subclasses he mentioned in "The Telltale Chart"--small, value, etc.--exhibited mean reversion; that the mean to which they were reverting was the total market; and--I'm trying to remember just where he makes this clear--that he thought of mean reversion as an active compensating process. That is, a run of outperformance was not merely likely to end, but likely to be followed by a counterbalancing run of underperformance.

[arcticpineapplecorp.]

I wish that people would be more welcoming to less sophisticated users like me and not speak in tongues. What does CAPM stand for?

The capital asset pricing model - or CAPM - is a financial model that calculates the expected rate of return for an asset or investment. CAPM does this by using the expected return on both the market and a risk-free asset, and the asset's correlation or sensitivity to the market (beta).
https://www.google.com/search?client=fi ... 1-d&q=capm

[nisiprius]

I wish that people would be more welcoming to less sophisticated users like me and not speak in tongues. What does CAPM stand for?

It stands for the Capital Asset Pricing Model, a body of theory for which William F. Sharpe was awarded the Nobel prize.

The CAPM framework assumes that stocks are stocks and that the ways in which an individual stock, or stock portfolio differs from the market can be summarized in two numbers: alpha and beta. "Beta" measures the volatility or risk as a multiple of the volatility of the whole market. Investors will not take more risk unless they expect to be rewarded for it, so it is a truism that riskier investments are expected by investors to have higher returns. Those returns may not materialize because that's what "risk" means. But the concept helps us not to be fooled by funds that have had higher returns simply because the manager has been taking more risk. "Alpha" measures the difference in return that cannot be explained by beta. Alpha is extra return that does not come simply from taking more risk. When you see references to managers "generating alpha," that's what it means--outperformance that does not come with more risk.

A popular school of thought is that CAPM did not provide an adequate fit to reality, and has been superseded by a new! improved! model involving multiple risk factors. The seminal work involved two papers by Fama and French in 1992 and 1993. They said they had identified two risk factors in stocks: "size" and "value." To explain as much as can be explained about a stock, it was not sufficient to measure alpha and beta, you also needed to measure how much of the size factor and how much of the value factor it had.

Fama and French's work triggered an academic gold rush to find more factors, and other academics claimed to have found more than a hundred of them. After the shakeout, Fama and French published a revised five-factor theory, while others found other sets of factors.

[nedsaid]

I wish that people would be more welcoming to less sophisticated users like me and not speak in tongues. What does CAPM stand for?

Capital Asset Pricing Model.

[enad]

Apparently he believed there was no increase in returns long term from holding SC? This is clearly wrong even for the time period outside of 73-83. Does he not believe in the basic idea of CAPM? In the quote below, he states that the reuts of SC vs LC have essentially been the same in the last 100 years, outside of 73-83. I take a look at the charts and they tell a completely different story. For example, since 1984, the S&P 400 has nearly doubled the returns of the S&P 500. Little confused on the quote.

“Few investment principles,” he said, “have been as unchallenged as the now-perennial assertion that over the long run, small-cap stocks have outperformed large-cap stocks”. Apart from the period 1973 to 1983, when small-caps comfortably beat large-caps, Bogle pointed out that the two strategies have produced pretty similar results since 1928, and that, over time, the winning streaks enjoyed by each have more or less cancelled each other out.

In his first book "Bogle on Mutual Funds" Chapter Four "How to Select a Common Stock Mutual Fund, Jack states:

On page 69: "The primary mainstream funds, as I noted, include growth funds and value funds. In practice, there is a soft distinction between these two stock fund classes. While their short-term returns have varied from one period to another, their long-term returns have been fairly similar. Admittedly, looking at five-year aggregates blurs much of the distinction between the returns of these two stock fund categories. But on a year-by-year basis over an extended period, a slow cyclical pattern emerges in which first one type of fund leads the market, then the other."

On page 70: "... it seems to me, is that there are few profits -- and lots of problems -- in trying to predict the relative performance of these two investment styles."

On page 71 he states "small company stocks have, over the long term, outperformed their larger capitalization cousins (1973-1992), which dominate the typical growth and value fund portfolios. However, there have been protracted periods when large company stocks performed better ... While small cap stocks provider higher returns over the full period, their dominance was achieved prior to 1984. Since then, large cap stocks have been by far the better performers."

On page 95 he concludes: "Limit narrowly based funds (such as international and small company funds) to perhaps 20% of your equity assets in the aggregate. Do not try to beat the market by engaging in short-term trading among sector funds.

[bikechuck]

I wish that people would be more welcoming to less sophisticated users like me and not speak in tongues. What does CAPM stand for?

Capital Asset Pricing Model.

Thanks nedsaid!

I hate acronyms ... if part of the reason for this forum is to promote financial literacy for less sophisticated investors they do nothing to help that objective.

[NiceUnparticularMan]

But a fraction of false positives in one data set will be false positive again in a different dataset.

Sure, but some factors have survived multiple out of sample tests--different time periods, different markets, and so on.

It is always theoretically possible that is "pure luck" but the chance of that being true becomes rather small under such conditions.

In the end, this is not a new issue for empirical research, and a lot of people over time are well aware of the problem and have carefully tested for these issues. I am really just pointing out that is a better approach than eyeballing charts and hand-waving arguments.

By the way, as a final thought--one could argue that CAPM itself is no more privileged in this sense than any other model. Meaning even a single "equity risk premium" could be "pure luck"--in theory.

I don't believe that is likely, but if you are not doing careful empirical work, just pointing out theoretical possibilities, then there is no particular reason to draw the line between CAPM and multi-factor models. You should be saying any observed difference between stocks and very low risk assets could be pure luck. Which is technically true.

[nisiprius]

A big problem, at least for me, in all of this stuff is drawing the line at the date when a factor, alternative investment, or strategy became a) generally known, and b) available to retail investors in a practical form.

Before that date, you have paper studies, backtesting, academic numbers which may not be investable... and unverifiable anecdotes about how unnamed "advisors" used them with great success for decades before the academics discovered them.

After that date, it seems like it is more than coincidence that many of them turn a corner and bend downwards on the chart. A -30% decline in the premium is acknowledged and documented by the factor advocates, but it sure seems like more than that.

In the case of small-caps, consider the real-world story of the DFA US Micro Cap Portfolio. DFA was founded in part for the specific purpose of making the size premium investable. It had inception almost immediately with the publication of the key paper by Rolf Banz, presenting the "small firm effect." DFA is generally considered to be highly skilled at managing factor funds. It uses a form of mild active management to overcome operational problems with buying very-small-cap stocks. Ut dips deeper into small-caps than competitors' small-cap index funds. Inception was 12/23/1981, giving us forty years of history.

Can you think of a fairer test of the benefit of small-cap stocks to real investors in the real world?

In that time, it's had two bursts of outperformance, one in its first three years, one in 2003-2004. It outperformed the S&P 500 by quite a lot for three years. It then underperformed for seventeen, giving back all of the outperformance. The second burst in 2003-2004 brought it slightly ahead of the S&P, but it then slightly underperformed over the next twenty years, bringing it just about back to even.

As best I can determine it,

DFSCX (small-caps) averaged 11.50% annual return
VFINX (Vanguard 500 Index Fund, S&P 500) averaged 11.33%.





Awkwardly for easy comparisons, PorfolioVisualizer's data for DFSCX doesn't begin until 1984 and is thus unfair to DFSCX because it is missing an early burst of outperformance, so please imagine pushing the red curve up until the right ends visibly coincide.

Source

[Call_Me_Op]

Did he mean "outperform" on an absolute basis or risk-adjusted basis? Many people think in terms of the latter.

[Logan Roy]

Apparently he believed there was no increase in returns long term from holding SC? This is clearly wrong even for the time period outside of 73-83. Does he not believe in the basic idea of CAPM? In the quote below, he states that the reuts of SC vs LC have essentially been the same in the last 100 years, outside of 73-83. I take a look at the charts and they tell a completely different story. For example, since 1984, the S&P 400 has nearly doubled the returns of the S&P 500. Little confused on the quote.

“Few investment principles,” he said, “have been as unchallenged as the now-perennial assertion that over the long run, small-cap stocks have outperformed large-cap stocks”. Apart from the period 1973 to 1983, when small-caps comfortably beat large-caps, Bogle pointed out that the two strategies have produced pretty similar results since 1928, and that, over time, the winning streaks enjoyed by each have more or less cancelled each other out.

Here's the AQR paper, from 2020, There Is No Size Effect.
https://www.aqr.com/Research-Archive/Pe ... ly-Edition

So I'd say Bogle's vindicated here. I seem to recall him saying something similar about stock market and long-term bond returns, but we've not been able to find it since. It may have been Berstein? But I'm inclined to think Bogle's right. I don't think the market compensates risk above the level of risk taken. Same as gambling markets don't give a persistent premium for betting on long shots. I've never been happy with the factor model. It doesn't seem robust enough. Without the facade of academia, it just looks like what Ben Graham was doing 50 years earlier. I don't think it makes sense for the market to encourage higher risk-taking.

[JoMoney]

... Does he not believe in the basic idea of CAPM?..

What do you believe "the basic idea of CAPM" is?
If you're asking if John Bogle believes that "High Beta Stocks" as a group will have higher returns, I would agree that's not something he believed, and there are numerous quotes from Mr. Bogle alluding to the idea that the "Efficient Market Hypothesis" and the various models built around it (like the idea of "Risk Premiums") are not the basis for investing in broad-market index funds. Mr. Bogle definitely used the Sharpe ratio and other CAPM related measurements for various purposes, but not as a method for picking portfolios likely to have higher returns, and rejected the idea that people should even attempt to chase returns. If I was to characterize what I thought Mr. Bogle's view on modeling the market was, my perception was that it was closer to Benjamin Graham's, which was of a very competitive market (where some people do have better positions and information,) and that most people should recognize that's not them and accept the "average" market return rather than trying to beat it, since regardless if the market is "efficient" or not, it's still a zero-sum game in aggregate, the market return in aggregate will not earn anything extra regardless of how people decide to trade their portfolios, for every portfolio that earns something extra there has to be one earning less.

[burritoLover]

In the longest running funds since Fama and French's 3-factor paper, DFA small cap and small cap value funds have both outperformed the Vanguard 500. This is not a free lunch - higher volatility and higher drawdowns are what you ended up with. As should be expected as both small and value are riskier than the market portfolio.

[goblue100]

I wish that people would be more welcoming to less sophisticated users like me and not speak in tongues. What does CAPM stand for?

From the FAQ, which is linked at the top of the page next to the ?:
Where can I find a list of abbreviations and acronyms?
A list of abbreviations and acronyms can be found in the wiki. See: Abbreviations and Acronyms
https://www.bogleheads.org/wiki/Abbrevi ... d_acronyms

[Ben Mathew]

By the way, as a final thought--one could argue that CAPM itself is no more privileged in this sense than any other model. Meaning even a single "equity risk premium" could be "pure luck"--in theory.

I don't believe that is likely, but if you are not doing careful empirical work, just pointing out theoretical possibilities, then there is no particular reason to draw the line between CAPM and multi-factor models. You should be saying any observed difference between stocks and very low risk assets could be pure luck. Which is technically true.

One way to reduce the probability of false positives is to ask how ex ante justified (i.e. rooted in reasonable theory) a factor is. By that metric, CAPM is at a completely different level than the other factors. While CAPM makes some specific assumptions about preferences, the broader idea that assets that pay out in good times will be cheaper than assets that pay out in bad times follows directly and naturally from basic economics. It's as fundamental as the idea of risk. The theory is so strong that if CAPM (broadly interpreted) didn't work, then that would be the puzzle. CAPM does in fact work better than most people give it credit for. Stocks are cheaper (have higher expected returns) than bonds. Call options on the market portfolio are cheaper (have higher expected returns) than put options on the market portfolio. My interpretation of this is that whenever people explicitly contract on aggregate market performance (like stocks vs bonds, and call vs put options), you see the response more clearly than when we are using historically estimated correlations of assets.

The other factors are basically empirical. Somebody finds something empirical, maybe some theory follows. The idea that small firms for example should pay a premium does not come from basic economics. If it is empirically true, then that would be a puzzle for which someone has to come up with a more narrow and specific theoretical justification.

None of this is to say that other factors don't empirically exist. I tilt to small value myself. But I still think that it's on shakier grounds than the market factor. Factor enthusiasts have taken to describing the market factor as just one factor of many. But theoretically at least, it's a very different kind of thing.

[9-5 Suited]

The idea that small firms for example should pay a premium does not come from basic economics. If it is empirically true, then that would be a puzzle for which someone has to come up with a more narrow and specific theoretical justification.

I assume that, on average, smaller companies have higher cost of capital than their well-entrenched industry leading counterparts. Like McDonalds probably gets better rates on it's corporate bonds than Jim Bob's Regional Burger Chain. So wouldn't it follow that in order to make an equity investment in Jim Bob's Regional Burger Chain, you would demand a higher expected return for similar reasons? Otherwise you could invest in the safer McDonalds operation.

Whether or not that higher expected return proves worthwhile when the real risk is accounted for and the actual returns come in is (of course) uncertain. Aggregating across a large group of big and small companies, perhaps the risk is just priced so well that comes out in the wash and the end returns end up being similar in most cases.

[Ben Mathew]

The idea that small firms for example should pay a premium does not come from basic economics. If it is empirically true, then that would be a puzzle for which someone has to come up with a more narrow and specific theoretical justification.

I assume that, on average, smaller companies have higher cost of capital than their well-entrenched industry leading counterparts. Like McDonalds probably gets better rates on it's corporate bonds than Jim Bob's Regional Burger Chain. So wouldn't it follow that in order to make an equity investment in Jim Bob's Regional Burger Chain, you would demand a higher expected return for similar reasons? Otherwise you could invest in the safer McDonalds operation.

This would be true if investors are not diversified and looking at the risk of companies in isolation. In that world, an investment in a small company would be riskier than a smaller share of a larger company. Investors should demand a higher return from such a company.

But when investors have the ability to diversify across companies, they can diversify away the idiosyncratic risks of individual companies. The risk that stems from being small is diversifiable. Holding a small fraction of many companies will eliminate it. What becomes relevant then is the risk that cannot be diversified away, which is whether it tends to systematically pay out in good or bad states--i.e. correlations to the market portfolio. A small company that pays out in bad states will be more attractive to an investor than a big company that pays out in good states, even if the small company is individually riskier. A simple example that neatly illustrates this principle is a put option on the market portfolio. It's very risky and volatile as an individual asset. But it's expensive (has a low expected return) because it pays out precisely when things are bad.

[9-5 Suited]

This would be true if ...

Thanks for the follow up - appreciate the detailed thoughts. I'm with you on the put option example and the diversification across a large pool of companies is what I was referencing in my last paragraph of the initial comment. But there's still just something about it I'm having trouble shaking from my head.

Another example might be venture capital, investing in some of the smallest operations out there right now. With the skewed return profile they have - despite investing in potentially hundreds of companies to diversify idiosyncratic risk - I presume they still seek a return on capital in excess of what the S&P500 is expected to return. And wouldn't the reason for that, at least in part, be the size of the startups they invest in? Those companies have no moat, limited ability to access certain forms of capital, no ability to cut back workforces temporarily, etc. and their current size seems like a big explanatory factor as to why.

[Ben Mathew]

This would be true if ...

Thanks for the follow up - appreciate the detailed thoughts. I'm with you on the put option example and the diversification across a large pool of companies is what I was referencing in my last paragraph of the initial comment. But there's still just something about it I'm having trouble shaking from my head.

Another example might be venture capital, investing in some of the smallest operations out there right now. With the skewed return profile they have - despite investing in potentially hundreds of companies to diversify idiosyncratic risk - I presume they still seek a return on capital in excess of what the S&P500 is expected to return. And wouldn't the reason for that, at least in part, be the size of the startups they invest in? Those companies have no moat, limited ability to access certain forms of capital, no ability to cut back workforces temporarily, etc. and their current size seems like a big explanatory factor as to why.

A venture capitalist who is investing time and effort looking for promising firms is providing a service to investors for which they get to charge fees. They can also seek to earn a return by investing their own capital. Whether through fees or through investing their own capital, the risk they take necessarily involves idiosyncratic risk that they can't diversify away. So they have to demand excess returns from the firms they invest in to cover that risk. But we should expect that this excess return will be absorbed by the venture capitalist's fees and profits. None of it needs to flow through to retail investors who are not doing any of the work and can remain broadly diversified in the overall market. Venture capital is just an asset class to retail investors. They can't demand excess return (beyond market beta) from any asset class, including venture capital. If the VC asset class did provide excess returns, then all retail investors would want to pile in, raising VC fees, and driving down post-fee returns.

[David Jay]

I wish that people would be more welcoming to less sophisticated users like me and not speak in tongues. What does CAPM stand for?

Your friends here on BH have done the work of giving you a glossary of abbreviations and acronyms, keep this link handy: https://www.bogleheads.org/wiki/Abbrevi ... d_acronyms

[bikechuck]

I wish that people would be more welcoming to less sophisticated users like me and not speak in tongues. What does CAPM stand for?

Your friends here on BH have done the work of giving you a glossary of abbreviations and acronyms, keep this link handy: https://www.bogleheads.org/wiki/Abbrevi ... d_acronyms

The glossary is much appreciated. That said many people that I have recommended this forum to tell me that they gave up on it because they could not understand so many of the posts. I do think that if people made more of an effort to avoid the use of acronyms it would make this space more welcoming and it would help promote financial literacy.

[garlandwhizzer]

As nisi's post points out comparing DFA's Microcap fund which has the heaviest loading of the small factor to the S&P 500 over the last 38 years, there is no harvestable premium in small alone. In fact, a very small loss. On the other hand, burritoLover pointed out that DFA SC1 fund, managed to harvest a modest (0.49%) premium over the same long period. Meanwhile factor models show a much more robust premium over the same time period. What are we to make of this?

First, in real funds trading in the SC space, when the market cap gets too small, increased trading frictions, illiquidity restraints, and increased trading costs actually produce a loss relative to LCB. All three of these things increase costs and reduce efficiency. Raise the average cap weight of the fund a bit like the SC1 fund and choose stocks skillfully that are more liquid and can be bought and sold with lower costs and there is a small premium over 38 years. Factor models ignores illiquidity, ignore trading costs and assume that you can sell and buy 100% of your SC stock holding at either the open or the closing price of the day. That of course is a joke in the real world particularly when you're talking about buying or unloading a large volume of SC stock. When you try to sell your shares the buy bid goes progressively down as the sale progresses. The opposite happens when you try to buy. Massive inefficiency and increased costs are inherent in trading mutual fund volumes of SC stocks. You can move hundreds of millions of dollars of LCB stocks without budging the price you pay for buying or for selling and trading costs are very low. That is the bar that SC funds must overcome.

Prior to 1984, SC stocks languished. Investors did not pay attention to them. Most investors then were mom and pop types and they ignored SC stocks. Hence there were some outrageously attractively priced SC stocks. They were poised for the great rebound which occurred when the Nifty Fifty (LCG) and ever increasing inflation devastated LCG and investors fell out of love with LCG which they also did in 2000-3, and more recently in 2022. At those market turning points, overlooked and much cheaper SC and SCV starts getting investor's attention.

There is the potential for a harvestable SC premium and a SCV premium of modest size after costs, but whether it will occur is certainly not guaranteed. The smallest of the small do not win. The most valuey and smallest cap of SCV funds also often turn out to be losers. Take a look at RZV, S&P Small Cap 600 Pure Value Fund, a deep value micro-cap fund, maximizing the small and value factors, relative to the S&P 500 since RZV's inception. RZV has drastically underperformed VOO since its inception in 2006 and done so with a lot more volatility, deeper losses, and a much lower Sharpe ratio

In SCV as in all factor funds, you not only have to pick the right factor(s) but also the right fund to harvest it after costs if you wish to outperform long term. The same is true for active management.

Garland Whizzer

[9-5 Suited]

A venture capitalist who is investing time and effort looking for promising firms is providing a service to investors for which they get to charge fees. They can also seek to earn a return by investing their own capital. Whether through fees or through investing their own capital, the risk they take necessarily involves idiosyncratic risk that they can't diversify away. So they have to demand excess returns from the firms they invest in to cover that risk. But we should expect that this excess return will be absorbed by the venture capitalist's fees and profits. None of it needs to flow through to retail investors who are not doing any of the work and can remain broadly diversified in the overall market. Venture capital is just an asset class to retail investors. They can't demand excess return (beyond market beta) from any asset class, including venture capital. If the VC asset class did provide excess returns, then all retail investors would want to pile in, raising VC fees, and driving down post-fee returns.

Thanks for the explanation! Makes sense.

[Northern Flicker]

Apparently he believed there was no increase in returns long term from holding SC? This is clearly wrong even for the time period outside of 73-83. Does he not believe in the basic idea of CAPM? In the quote below, he states that the reuts of SC vs LC have essentially been the same in the last 100 years, outside of 73-83. I take a look at the charts and they tell a completely different story. For example, since 1984, the S&P 400 has nearly doubled the returns of the S&P 500. Little confused on the quote.

The S&P400 is a midcap index.

The question of whether there is a size (smallcap) premium is still debated by factor experts, so there is not going to be a simple, clearcut answer.

The S&P600 has a value tilt and a quality tilt, so the S&P600 overperforming would not necessarily imply that there is a size premium.

https://www.portfoliovisualizer.com/fac ... sion=false

[Apathizer]

In the longest running funds since Fama and French's 3-factor paper, DFA small cap and small cap value funds have both outperformed the Vanguard 500. This is not a free lunch - higher volatility and higher drawdowns are what you ended up with. As should be expected as both small and value are riskier than the market portfolio.

Considering their volatility, I don't think small caps as a whole are all that beneficial since their returns are only slightly higher. However, it seems worthwhile for SCV, which has average returns about 1.5% higher.

[Fryxell]

While CAPM makes some specific assumptions about preferences, the broader idea that assets that pay out in good times will be cheaper than assets that pay out in bad times follows directly and naturally from basic economics. It's as fundamental as the idea of risk. The theory is so strong that if CAPM (broadly interpreted) didn't work, then that would be the puzzle.

Are you sure about that?

Wikipedia: https://en.m.wikipedia.org/wiki/Equity_premium_puzzle

The equity premium puzzle refers to the inability of an important class of economic models to explain the average equity risk premium (ERP) provided by a diversified portfolio of U.S. equities over that of U.S. Treasury Bills, which has been observed for more than 100 years. There is a significant disparity between returns produced by stocks compared to returns produced by government treasury bills.[1] The equity premium puzzle addresses the difficulty in understanding and explaining this disparity.

The authors found that a standard general equilibrium model, calibrated to display key U.S. business cycle fluctuations, generated an equity premium of less than 1% for reasonable risk aversion levels. This result stood in sharp contrast with the average equity premium of 6% observed during the historical period.

The intuitive notion that stocks are much riskier than bonds is not a sufficient explanation of the observation that the magnitude of the disparity between the two returns, the equity risk premium (ERP), is so great that it implies an implausibly high level of investor risk aversion that is fundamentally incompatible with other branches of economics, particularly macroeconomics and financial economics.

The other factors are basically empirical. Somebody finds something empirical, maybe some theory follows.

Nah, the equity premium is “empirical” too. It was not predicted ex ante. People developed a theory for it after noticing equities provided greater returns than bonds. Same as with the value, size, and other factors.

There is a risk story for many factors. For instance, small companies are more likely to go bankrupt than large ones, as they are less diversified.

If you accept that equities have a premium because they are riskier than bonds, then why should we suppose that all equities have the same level of risk? Once you accept the notion of risk premia, then you have to acknowledge that riskier stocks would be expected to provide greater returns than less risky stocks.

[Fryxell]

This would be true if investors are not diversified and looking at the risk of companies in isolation. In that world, an investment in a small company would be riskier than a smaller share of a larger company. Investors should demand a higher return from such a company.

Ok, so shouldn’t this apply to equities too, especially now that we have index funds where we can diversify away the risk of individual equities?

[watchnerd]

I wish that people would be more welcoming to less sophisticated users like me and not speak in tongues. What does CAPM stand for?

Capital Asset Pricing Model.

Thanks nedsaid!

I hate acronyms ... if part of the reason for this forum is to promote financial literacy for less sophisticated investors they do nothing to help that objective.

CAPM is a finance industry standard jargon term.

On might not like acronyms, but Bogleheads didn't invent the abbreviation CAPM and it shows up in scores of text books and books on investing.

[Ben Mathew]

While CAPM makes some specific assumptions about preferences, the broader idea that assets that pay out in good times will be cheaper than assets that pay out in bad times follows directly and naturally from basic economics. It's as fundamental as the idea of risk. The theory is so strong that if CAPM (broadly interpreted) didn't work, then that would be the puzzle.

Are you sure about that?

Wikipedia: https://en.m.wikipedia.org/wiki/Equity_premium_puzzle

The equity premium puzzle refers to the inability of an important class of economic models to explain the average equity risk premium (ERP) provided by a diversified portfolio of U.S. equities over that of U.S. Treasury Bills, which has been observed for more than 100 years. There is a significant disparity between returns produced by stocks compared to returns produced by government treasury bills.[1] The equity premium puzzle addresses the difficulty in understanding and explaining this disparity.

The authors found that a standard general equilibrium model, calibrated to display key U.S. business cycle fluctuations, generated an equity premium of less than 1% for reasonable risk aversion levels. This result stood in sharp contrast with the average equity premium of 6% observed during the historical period.

The intuitive notion that stocks are much riskier than bonds is not a sufficient explanation of the observation that the magnitude of the disparity between the two returns, the equity risk premium (ERP), is so great that it implies an implausibly high level of investor risk aversion that is fundamentally incompatible with other branches of economics, particularly macroeconomics and financial economics.

The other factors are basically empirical. Somebody finds something empirical, maybe some theory follows.

Nah, the equity premium is “empirical” too. It was not predicted ex ante. People developed a theory for it after noticing equities provided greater returns than bonds. Same as with the value, size, and other factors.

What comes out of basic economics--just from the idea that things that are plentiful should be cheaper than things that are scarce--is that there should be an equity premium. The size of that premium is harder to pin down and is an empirical matter. The equity premium puzzle refers to the observation that some empirical estimates of the equity premium seems large relative to empirical estimates of risk aversion in other settings, not that the premium exists.

CAPM was not invented to explain the equity premium puzzle. It has nothing to say about the size of the premium. It takes the size of the equity premium as given and tries to explain the expected returns of other assets based on that. The size of the premium is an input rather than an output of the model, and is not explained by CAPM.

There is a risk story for many factors. For instance, small companies are more likely to go bankrupt than large ones, as they are less diversified.

If you accept that equities have a premium because they are riskier than bonds, then why should we suppose that all equities have the same level of risk? Once you accept the notion of risk premia, then you have to acknowledge that riskier stocks would be expected to provide greater returns than less risky stocks.

CAPM is not saying that all stocks have the same level of risk. What it's saying is that the risk of individual assets or asset classes should be evaluated in the context of a well diversified portfolio, not in isolation. With some assumptions, that means that what matters is correlations to the market portfolio, not how volatile the asset is on its own.

[watchnerd]

CAPM is not saying that all stocks have the same level of risk. What it's saying is that the risk of individual assets or asset classes should be evaluated in the context of a well diversified portfolio, not in isolation. With some assumptions, that means that what matters is correlations to the market portfolio, not how volatile the asset is on its own.

Which has interesting implications of one chooses to hold the global market weight portfolio of stocks / bonds (as I do).

[bikechuck]

I wish that people would be more welcoming to less sophisticated users like me and not speak in tongues. What does CAPM stand for?

Capital Asset Pricing Model.

Thanks nedsaid!

I hate acronyms ... if part of the reason for this forum is to promote financial literacy for less sophisticated investors they do nothing to help that objective.

CAPM is a finance industry standard jargon term.

On might not like acronyms, but Bogleheads didn't invent the abbreviation CAPM and it shows up in scores of text books and books on investing.

You are correct in describing it as finance industry jargon.

[Anon9001]

Apparently he believed there was no increase in returns long term from holding SC? This is clearly wrong even for the time period outside of 73-83. Does he not believe in the basic idea of CAPM? In the quote below, he states that the reuts of SC vs LC have essentially been the same in the last 100 years, outside of 73-83. I take a look at the charts and they tell a completely different story. For example, since 1984, the S&P 400 has nearly doubled the returns of the S&P 500. Little confused on the quote.

“Few investment principles,” he said, “have been as unchallenged as the now-perennial assertion that over the long run, small-cap stocks have outperformed large-cap stocks”. Apart from the period 1973 to 1983, when small-caps comfortably beat large-caps, Bogle pointed out that the two strategies have produced pretty similar results since 1928, and that, over time, the winning streaks enjoyed by each have more or less cancelled each other out.

if we look at the Rolling 20 Year IRR of VFINX vs DFSCX the former actually has only outperformed the later only recently. Its quite impressive the performance here considering how the Size Premium is considered to be insignificant now. The Average 20 Year IRR for VFINX and DFSVX is 8.2%, 9.8% respectively.