Apollo Lupescu returns to The Wealth Cast for episode 26, joining Chas Boinske to talk about value and small cap investing and their potential for increased returns in an investment portfolio. They break down the concepts, simplifying them for even beginning investors, then review the relevant risks and rewards. They also stress the importance of staying the course, whichever investment strategy is chosen, and the importance of an advisor to guide any investor through the rough patches.
Hello, and welcome to The Wealth Cast. I’m your host Charles Boinske. On this podcast we bring you the information that you need to know in order to be a good steward of your wealth, reach your goals, and improve society. Today I’m joined by my friend Apollo Lupescu. Apollo is the Vice President at Dimensional Fund Advisors, and has been a frequent guest on this program. The reason I always enjoy the conversations I have with Apollo is that he can take relatively complicated concepts and explain them in relatively simple terms. And today, we’re going to talk about something called the Value and Size Risk Premia, and why investors may earn returns from exposing their portfolios to those factors. And what the logical underpinnings for expecting that extra return may be from an economic perspective. I hope you enjoy the conversation. Thanks very much for joining us.
Welcome to The Wealth Cast once again.
Chas, it’s great to see you. Great to talk to you. Thank you for having me back. It’s a true honor.
Yeah, it’s always a pleasure. And I’m really thrilled to have you on the show today to talk about the Value and Size Premia, and the impact that they may have on a portfolio and the theoretical underpinnings behind them, etc. So you’re just the guy to talk to, so thanks for coming.
Hey, it’s my pleasure. Thank you again for having me.
Sure. So what why don’t we start sort of at 60,000 feet and talk about, what’s the rational economic—the sensible reason—why investors might want to consider having exposure to Value and Small stocks in their portfolio.
One of the very interesting questions that has been on the mind of academics and practitioners, going back to the 1970s, is trying to look at stocks, and try to identify the different parts of the market, the different asset classes that have different expected returns. We know that stocks are stocks. They provide investors with ownership into companies. But we also know intuitively that not all stocks would have the same expected returns. So being able to categorize them and organize them into these asset classes has really been a really important challenge to the investment professionals.
In the early 1980s and late 70s, academics had started to move away from looking at industries, sectors—the way that typically it’s presented today: you have pharmaceutical, you have transportation, technology. That was the way in which people looked at the world back in the 1970s. But what they found is that there’s no real economic theory that they would distinguish the different expected returns, and also, the data wasn’t quite there to support a distinction of asset classes based on industry and sectors. So even though today we still use sectors as a way to differentiate stocks, since the 1970s, I think practitioners and the more scientific research community has shifted into a different way of organizing stocks into these asset classes—asset classes, just simply being a basket of stocks or groups of stocks with similar characteristics when it comes to expected returns.
And in the 1970s, late 1970s and early 80s, an academic from the University of Chicago—his name is Ralph Bonds—proposed a pretty interesting theory. And in his mind, when you look at the size of a company, that tends to matter, in terms of both economically for the company, but also when you look at the data. And what I mean by that is that smaller companies—they tend to behave a little bit differently than large companies, in the sense that large companies do have a longer track record. They have, you know, obviously, they’re bigger, they’ve been through more things. And these large companies have a different economic profile than their smaller counterparts. And that was way back in the 1970s and early 80s.
And let’s just make this real, Chas. When you think of a large company, let’s just visualize perhaps McDonald’s. It’s a, you know, very big burger chain, we all know about it. It’s in so many countries, it’s larges, it’s robust, and let’s just make that the poster child of large companies. On the other hand, across the country, there’s another burger chain that’s popping up and it’s actually, you know—opened one just next to me, and it’s called Shake Shack. They’re both publicly traded companies, they both are burger joints, and yet when you think of McDonald’s, you know, it’s a little bit different economically than Shake Shack. It has a longer track record, it supposedly has more sources of financing, it has better processes developed over the years.
So when you think of it, and you look and say, as an investor, if I have, you know, the opportunity to invest in Shake Shack and McDonald’s, well, which one would I invest in if I had the exact same expected returns in both? And most people would say, “Well, I would say that probably McDonald’s, because why take the additional uncertainty of a smaller company that’s not as proven as large companies?” So there is a difference in the cost of capital between Small and Large, and this is what investors require in order to deploy capital into those companies.
So there’s an economic intuition, and also, even if you go beyond the economic intuition, if you just simply look and say, “Well, okay, you got McDonald’s and Shake Shack. Which one is more likely to grow, and let’s say double in size?” It seems like McDonald’s could, but certainly not as easy to imagine as a Shake Shack. So from a growth perspective, it’s also different.
So when you combine this idea that a small company perhaps has more room to grow, and on the other hand, it should have perhaps a higher cost of capital relative to a larger counterpart—at that point, there is some economic intuition suggesting that when you look at these two different asset classes—large companies and small companies—perhaps they should not have the same expected return. And there was a high level of intuition that was brought forth to differentiate asset classes based on the company size.
And Chas, just to quickly—I know that you hear a lot [about] company size, and it might be confusing to some folks. What do I mean size? Because there are different ways in which you can measure a company. What we’ll refer to in this podcast as size, is looking at a metric called capitalization—market capitalization. And what it means is that every single company has shares of ownership, and individuals own these pieces of ownership, the share of ownership. And each one of these shares of ownership has a certain value. When you multiply the number of shares of ownerships by the price for each share, you get a combined value of all the ownership in that particular company, and that is called market capitalization. So it doesn’t have to do with employees, it doesn’t have to do with sales, it has to do with how many shares does a company have, and how much does each share cost. And when you multiply the two, you get this idea of market capitalization. When we’re talking about Small Caps, that means that the value of the capitalization is smaller than perhaps a Large Cap company.
Yeah, that’s just, that makes total sense, and I think is relatively easy to to understand. So thanks for that.
Going back to one thing you said, you talked about, you mentioned the cost of capital. And it may make sense to spend just a minute more or two on that topic, because I think we’ve discussed this before, Apollo—it’s sort of like one of the most important concepts to understand in terms of expected returns, because cost of capital expected return are basically the same figure. As an example, am I right in saying that if a small company goes to the bank for a loan, all things equal, Shake Shack goes to the bank for a loan in your example, they’re going to be charged a higher rate of interest than if McDonald’s goes to the bank for a loan.
And as a result, that interest rate that they’re being charged is their cost of capital. But conversely, from the bank’s perspective, the expected return on the loan to Shake Shack is higher than the expected return on the loan to McDonald’s, because they’re charging Shake Shack higher rate of interest.
For that reason, then, the cost of capital and expected return, in that example, are basically the same thing.
It’s the flip side of the same coin.
Yep. And so if that’s true, you know, risk and reward are related in that regard, you know, Shake Shack is riskier, it’s smaller, it doesn’t have the resources that McDonald’s has, etc, and it goes to the bank, its cost of capital is higher, the bank’s expected return on Shake Shack is higher. If the stock market didn’t work the same way, in the aggregate, then you would have this disconnect in risk and reward. That’s how I’ve sort of thought about it over the years, and I wondered if you had any comments on that idea?
You got it exactly. I think that if it didn’t work that way, we’d be in a heap of trouble, because a lot of things would break down around us. But you know, the way you put it, absolutely is spot on. And in fact, even, you know, I’m gonna refer to myself: I’m 50 years old. I’m 52 by now, actually. If I go to a bank right now, to the point that you made, I would be able to get a loan, and I would pay a certain interest rate, given that I’m at this point in my career, and I have this track record of paying my bills and taking care of my debt. So my cost of capital is basically the interest that I have to pay on the loan. Now the bank—to exactly the point that you made—to them, the return on the money is basically the interest that I pay. That’s the flip side of the same coin.
Now imagine that the same me would walk into the same bank 25 years ago, and ask for the same loan. Would I be charged the same rate? And to me, it’s unlikely because 25 years ago, I didn’t have the track record—I wasn’t at the point in my life where I am today. So the bank probably looked at me and said, “You know, I’ll give you a loan. But you know what, you at 25 are different than you at 50.” And if the same exact me would walk in the bank 25 years ago, my guess is that I would get the loan at a higher rate.
And that’s kind of exactly what you suggested, is that when you look at these companies, the level of track record and maturity and so forth, it does reflect in a very good analogy that you had, with a bank loan.
So another way to think about it is that maybe small caps are the “younger us.”
And the large companies are the “more mature us”—not necessarily not always the case, I mean, you can be an immature 50-year-old.
Point is that immature 50-year-old, you know, we’re going to come back to how the market can distinguish a mature 50-year-old versus immature—somebody who’s doing well versus not. Because even the large and small, not all companies are the same. And that’s an important piece that I’m sure we’ll touch on.
So if risk and reward are related—which I think it’s hard to argue that they’re not based on the academic data and the real life experience of investors—then we have to assume the stock market prices in risk in small companies like Shake Shack, relative to large companies like McDonald’s, and that investors in the Shake Shack shares should expect, or may expect, higher rates of return for taking the risk of buying Shake Shack. And all that makes sense from a sort of theoretical standpoint, and I believe that the academic data supports that idea—made famous by folks like Fama and French and small cap premias, etc. The same is true, then, in what we call value versus growth stocks, is it not?
Yeah, absolutely. And value versus growth is another iteration to being a little bit more precise on the drivers of these expected returns. So we knew back from the 19, early 80s, that small companies and large companies have different expected returns, and that the question in turn, “Well, what about all these large and small caps? Are they all exactly the same?” And the answer was, “Well, there’s another differentiator,”and that is exactly what you mentioned: value versus growth.
So let’s unpack this because you hear value versus growth, and I think there’s a lot of confusion out there. What is value? What is growth? These are not terms that are as easily understood as small/large. Small/large, it’s kind of easy, okay, that’s a big or a small, but what is value? What is growth? So let’s unpack that.
The idea of value companies actually goes back all the way to Benjamin Graham, because what Benjamin Graham—who was a very famous investor, published in books, and he was Warren Buffett’s mentor for that matter—what he suggested is that as an investor, what somebody ought to do is not just buy on hunches, but really have a more structured approach of analyzing companies. And ultimately, what you want to really consider is, how much are you paying for what you’re getting—which is a concept of value that’s in our in our everyday life, you know. We we want to get value. It’s not always about the low price, it’s about value. None of us go to the car lot and say, “Show me your cheapest car in the lot.” They just want to know what’s the best value.
So the idea of value has been with us for a long time. And what it is in investing is the idea that every minute, every second, the market takes into account all these different expectations and information about a particular company, and you can refer to that price relative to some accounting fundamental that is standardized, to get a sense of, what is the relative price between companies.
So let’s just make it real: I’m going to use an intuitive metric—which is not what we use—but it just for intuition purposes, I think quite often it gets the point across. As an investor, you know, you obviously have this ownership in companies and earnings are important, because ultimately, that’s what you’re buying as an investor—earnings and future cash flows. You can ask the question, “How much does it cost me as an investor to let’s say, to buy a dollar of earnings?” In some companies, you know, for the price might reflect that maybe you would pay $10 to buy $1 of earnings. For others it might be 15, for others it might be 20.
You’re buying the same dollar in earnings, but you pay different prices. And that’s kind of the idea of value and growth value companies typically reflect companies that have a relatively low price for this accounting fundamental. The one that, in more technical terms, that it’s a very good way to look at the distinction between value growth—it’s what’s called “book value.” And book value is simply what is the level of the assets after liabilities are paid? So it’s the book value of a company.
And you can say, “Well, how much would it cost me to buy $1 or $1 billion of his assets,” and then you look at the price relative to this book value, and you get a sense of the relative scale of how expensive companies are. So being able to rank companies based on this price, relative to an accounting fundamental that is standardized, allows investors to define a relative price. And the relative price is what defines value versus growth. The lower price stocks, they tend to be called “value,” the more expensive counterparts tend to be called “growth.”
Growth, you’re paying more, but there has to be a reason for that. If a company is doing everything, right? It’s got like, you know, it’s clockwork. You have a company that always generates, it’s very steady in its earnings. Well, at that point, you know, you might be paying a premium for the fact there’s a little bit more stability into the earnings of the company.
A value stock, on the other hand, you might have great potential for growth, but the earnings might be a little bit more uncertain, relative to another company. And that’s what the market’s trying to identify, is looking at these metrics, and then discounting these cash flows back. So just for tuition, I think it’s important to understand intuitively, what is value, what is growth, because you hear so many definitions. So value just simply reflects that you’re paying a lower price.
And most people would say, Listen, if I have two houses on the same block, one sells for $200 a square foot, the other one for $600 a square foot, which one is a more attractive investment—paying a lower price, or paying a higher price? And I think that the idea of value, paying a lower price, gives you more room to grow, if you’re going to use jargon.
Yeah. Understood. I think the important point that I think trips people up sometimes is that we’re not talking about—when we talk about paying a lower price, we’re not talking about the absolute price of the share in terms of dollars, right? Not $20 a share versus $30 a share. It has to be relative to the underlying economics of the company, whether that’s earnings, like you pointed out, or book value. And I think sometimes that trips folks up. They think lower price always means paying the lowest dollar per share in actual, you know, share price is not taking into context, the underlying economics of the business. And that’s, whenever we talk about price, in this conversation, I believe we’re talking about that price relative to its underlying economics.
Absolutely. You got it absolutely. And for most people, if they want to, one of the crudest measures, but it’s also something that it is intuitive, and so you can easily find it—you can go on your phone, and I’m not suggesting go follow stocks. But just to kind of define this idea, you can go and look for a metric called PE, which is stands for price/earnings, and it’s the price of the company divided by the earnings over the previous 12 months. So you have this ratio that tells you for the earnings of the company generated over the past 12 months, what’s the price that you’re paying today. And what’s fascinating is that that you have a company like Pfizer. And I’m not here to endorse any one company—don’t think this is a recommendation. But just to get an idea of the relative price just for intuition purposes, if you open up your phone today, what you find is that Pfizer has a PE of 20. So you know, price relative to earnings is 20 times, so you pay 20 times while the company made in the price. And that’s one. But on the other hand, you look at Tesla, which so many people are looking at exploring purchasing, to the same price/earnings ratio is over 600. So in other words, you know, as an investor, you’re paying 30 times more for the same dollar of earnings in Tesla, as you are in Pfizer. So an investor, and this is again, going back to Benjamin Graham, the idea that paying a lower price, it’s probably a good idea, and not just in investing.
But you can see these in the real world, and it’s fascinating, because, you know, some companies tend to be expensive, and yet people still want to clamor over them just because they’re on the news or something is shiny about them. But—and it might be a great investment. I’m not here saying Tesla’s not a good investment. What I’m saying is that, as an investor, we just want to make sure that we look at a relative price—what is the price relative to some fundamental—you can look at book value, you can look at earnings, you can look at cash flows. All of these are metrics that basically normalize and standardize this relative price of a share to an accounting fundamental. And that’s what we consider to be value versus growth.
Yep. Yeah, that makes sense to me. So as you’ve said before, the intuition supports the idea that value stocks should have higher expected returns than growth stocks, and that small stocks should have higher expected returns than large stocks. But we know that, you know, when the rubber meets the road, we don’t always experience that—you don’t experience that expected return differential, every period. And recent past is one example that, right? The last ten or so years, that relationship hasn’t existed. So how do we put that into context?
Yes, and that’s an interesting question, because quite often when people hear about this, you know, first of all, they’re, you know, “How come more people don’t do this? Or what’s the risk associated with this?” Because that’s an important question. “What’s the catch here? It seems like, is it a free lunch?” And the reality is, the way we define risk is quite interesting, because risk into the traditional way—which is still a very good measure of risk—is around volatility, which is a metric around how much do their actual returns spread from the mean, from the average. So how much fluctuation do you see in in returns? And that volatility is one measure of risk, and it’s certainly useful. Absolutely.
But at the asset class level, it turns out that when you incorporate all these different asset classes—you have large companies, small, value, growth, international, bonds, the individual volatility of any one asset class is not really as meaningful as the covariances or correlations between them. Because at the portfolio level, it is much more about how they interact with each other, than the individual volatility. So when you think about risk in this way of investing, it’s not necessarily the only way to think about it is standard deviation or volatility. What I consider to be the true risk of the strategy—and the reason that more people don’t do it—is because, as you said, when you hear this, it’s so intuitive, it makes you think that “Boy, every single day, small is going to beat large; value is going to beat growth.” And the thing is that this is not about certainty or guarantees, but it’s much more about understanding statistics, probability. It’s a data driven way of investing.
And what I mean by that: Every single day I do expect that small is going to outperform large and value is going to beat growth. That’s the expectation that I have every day. And let’s just make it real, Chas: I’m not a big skier, but I used to go quite often to Lake Tahoe, a beautiful spot. But you go to a ski resort, let’s just pick—so you go to Vail in January. Well, every single January, you expect to see snow on the ground. That’s the expectation, and I have it every January, I expect to see snow on the ground. That’s my expectation every January. Now if I show up in any one year, and I don’t see snow on the ground, I’m going to be bummed out. But on the other hand, I’m not going to change my expectation for next year. So I expect small to outperform, I expect value to outperform. But I also realize that that will not realize every single day, every single year.
So it’s about the expectation versus the realization, and that’s what I think that the issue is. Because if you look at the expectation: I have that. But does it realize every year? Is snow coming to Vail every year? The reality is no, it wasn’t in Tahoe. There were some years when it’s beautiful, and maybe there’s a few years when it’s not there. And it’s exactly the same with these, what’s called premiums. Premium meaning the difference in returns between small and large, and value and growth—those are called premiums—the difference in those returns. And what we see in the data is that that roughly, when you look on an annual basis, when you look at value, for example, outperforming growth, when you run simulations, what you see is that on an annual basis, roughly about 60% of the time—I think it’s 59%, to be precise, and I’ll send you the slides so you can post it perhaps with a link to the podcast—what you see is roughly about 59% of the time, value outperforms growth over one year. What it means is that, you know, if roughly six in 10 years, value outperforms the flipside of that is 4 in 10 years, it doesn’t.
So even on a one year basis—forget about daily or quarterly or monthly—even on a one year basis, I do have better odds of seeing value outperform, but it’s not a slam dunk. It doesn’t seem to be there every year. But the more you give the system time to work—so if you go from one year to five years—what you see is that the odds improve. You go from 59% to I think it’s about 72% after five years. And even if you look at 10 years, I think it becomes more like 80%, and so the odds improve that you will see this relationship of the premium being positive, but it’s not there every day.
And you know, when I saw this number, the first thought that I had is that, “Boy, you know, it could be a five year period, and in fact, about a quarter of the time—more than a quarter of the time, more than 25% of the time—after a five year period. I’m not going to see this, and I have to be okay with that.” But Chas, if you see these odds—if you see that value outperforms growth 72% of the time over five years, knowing it’s possible that you might run into the 28% time when it doesn’t, what would you like to do? Which makes more sense? Which asset class would you like to emphasize?
And again, if you saw these odds, which asset class would you like to emphasize? And what I mean here by emphasize is that it’s also good for investors not necessarily to jump all-in into small and value, because again, there’s going to be times when you’re not going to find these premiums. And having some level of diversification in large and growth might actually be smart. And the degree to which you want to do this is really how well you understand the system, and how comfortable you are with managing your own expectations.
But to me, the true risk of the system is people expecting this to be there every day, and if it hasn’t showed up for two or three or four years, they basically throw their arms up and say, “You know, I’m done with this. This doesn’t work, it’s not good, I’m done.” And that’s the issue, it’s that when you look at statistics, it absolutely happens, and even after 10 years, about roughly one in five periods of 10 years, we’re not going to see it. And we’re going through one of those right now.
Again, that’s part of what I would consider to be a behavioral risk of investing. And to me, it really highlights the role of an advisor. And I think it’s a huge value add by advisors, being able to make sure that clients stay disciplined and diversified through all these ups and downs of the premiums. And ultimately, what you see is that the folks who do, they tend to have a better investment experience. But you do need an advisor, absolutely 100% believe that you need an advisor for the system to work properly.
Well, one of the things that I think is clear to me that makes it easier: if it is intuitive, if it’s sensible, you can use intuition to say that this should probably be true, and then you back it up with data, like the value premium and the size premium—then it makes it a lot easier to stay with this strategy during those lean years. Because you know—you have a full understanding of what the reality of how these returns are going to be earned is, and you realize that shifting the strategy at the wrong time is probably more expensive in the long run, than sticking with a strategy that’s underpinned by data and intuition. In the short run, that’s just not working out for whatever, you know, because it just happens to be a period where it’s not working.
Absolutely. And in fact, one of the things that that both the academic community and also practitioners—a lot of folks have looked at this and say, “Can we somehow find a trigger that would tell us that the upcoming short period, short time ahead, short term ahead, might be more favorable towards value stocks or growth stocks, large or small?” So in other words, even as we understand these asset classes, are we better off staying disciplined in a particular location that was developed strategically for a client? Or are we better off trying to move in and out depending on what we might forecast to be a better performing asset class? We’ve looked at this: is there a way to determine whether, you know over the next, you know, 1, 3, 5 years, in the short run, value will outperform growth, or growth will outperform value, or small versus large? Is there a way to gauge when these premiums would show up and when they won’t, and make these tactical moves in the portfolio?
And certainly we’ve looked at this, a lot of folks have looked at this, and there’s no reliable way—there is no real robust way in the data to suggest that you can do this precisely and consistently. You might be able to do it once, maybe by luck or maybe by skill, but to do it consistently—it’s not something that we found is quite possible.
So even though I acknowledge that there is maybe—the obvious question, why not just move from value to growth, depending on where they might be going next? The reality is that nobody really knows the precise pattern of these returns to say, “Yeah, this is a good time for value. This is a good time for growth, small.” I wish this was the case [when] we looked at this. I think investors are better off staying disciplined and diversified. Those are the two ingredients of the strategy, and having an advisor to make sure that it’s built efficiently, because you have to apply the same exact criteria not only in the U.S., but abroad—international, developing and emerging markets—a very consistent approach that he can deploy globally. And an advisor has a tremendous role in making sure that all of these pieces of the puzzle fit together.
I think that’s been the the idea of having an investment policy or process that you can stick with, no matter what the current circumstances, is one of the keys to success over the long term, right? Just having the confidence that this investment strategy has really sound intuitive underpinnings, it’s got that intuitive thought is backed by data, and as a result, this is a well considered portfolio. We can stick through it, we know that there are going to be lean times and it’s really no different than stocks versus T-Bills.
You can go through long periods of time when stocks underperform T-Bills, yet no one is questioning the wisdom of investing in stocks over the long term—or I shouldn’t say no one is—but few people.
So no, I think that this obviously to me, all makes sense. And I think it’s one of the most important concepts that investors need to get their arms around. Once you understand the risk and reward relationship, the cost of capital and expected return relationship, and then backing up further to its intuitive sensibilities, then it makes it a lot easier to be successful over the long term.
Absolutely. And, you know, it’s so interesting because when investors are looking to do this without an advisor like you—and what’s interesting is that a lot of folks, even if they might understand this intuitively and say, “Okay, I ‘get’ small versus large, value versus growth,” just being able to capture these asset classes is not trivial. Because what we found—and there’s some great research that professors Fama and French did a few years ago—what you end up seeing is that in order for you to capture these, you have to be fully diversified within the asset class. It’s a really important concept. When you’re talking about small versus large, if you start cherry picking stocks in there, and just not being diversified, you actually have a very good chance of missing these premiums. Because what they found, it’s a great paper called “Migration” that was published maybe 10,15 years ago. And in that paper, what they found is that the majority of the premium was driven by a handful—a minority, I think it was 10-15% of companies in the asset class—are really this super high fliers. They have really outsized returns, and they drive the premium of the entire asset class. So in order to capture it, you need to be fully diversified, because again, it’s a handful of these stocks that are really driving a lot of the performance.
But the way to think about this, is that if you’re not fully diversified, and you miss these companies, then you might actually miss the performance of the premiums. And obviously, the next question was, “Can we identify just these super high fliers, and just hold those?” And we’ve looked at it—there’s no way to know which they are, which companies might be the high flyer. So you know, the true way to really capture these dimensions of the market is to really be so broadly diversified in funds that are across the entire asset class, and that’s a really very important consideration. Don’t look at just individual companies. It’s not about the individual fish. And I know Chas, you love to fish.
This is not about going there and fishing by the rod. This is fishing by the net.
Yeah, understood! It’s not one fish at a time. It’s a whole school of fish in one swoop. But you know, it’s interesting, because I think sometimes, as human beings, we either look at something as a “glass half empty” or “glass half full.” And the glass half empty view that in my view would be, “It’s impossible to pick just the 10 or 20 stocks that you mentioned, that ended up driving the returns of this asset class.” But to me, it’s really about being the glass being half full, in that you don’t need to worry about that. In order to get the returns from these premiums, you can take a diversified, low-cost approach to the strategy, and therein lies its biggest advantage. I think that sometimes that gets lost in the conversation.
Oh, absolutely. It’s interesting, because a lot of folks when they’re looking at investing, perhaps they’re thinking about, you know, “What’s the quickest way to make money?” or “How much money can I make?” without necessarily considering the risk associated with that.
To me, what you already pointing out is that when you think about investing, it should not be about, you know, “How much money can I make very quickly,” but it’s about, how can you get to point A, to point B in your financial life, while really mitigating risks. And the way to do that is by being fully diversified, and not having to worry that “I have a home run every day.” You don’t win baseball games by going for a home run, you just want to have enough runs.
Right, right. Getting people on base.
Yeah. But you know, Chas, there’s one thing that we keep talking about in this podcast, and I’m not sure if it’s of interest to the audience, but we talked about data. And data is really important. There is obviously intuition, but there’s data and we can certainly provide, there’ll be some links, maybe, to some data that to kind of show you some of these numbers, and what’s small versus large.
But we have a book that is called The Matrix Book. It’s been published for, you know, 20, 30 years, more than 30 years, almost 40 years now. It’s a book of—it’s an encyclopedia of investment numbers, if you want to call it that way. It has a lot of different asset classes and their returns, along with the growth of wealth in these different asset classes. So if you took a dollar and invested it, what would be the outcome.
And in this book, you can look at companies that are large, and probably the—you know, the most commonly used way to define large companies is the S&P 500, Standard and Poor’s 500. It’s a list of the largest 500 companies in the US market. And then you combine—you aggregate—them together. You say, “Well, what’s been the performance of the group of large company stocks?” So for large companies, let’s just use the S&P 500. And in the book, there’s also a Small Company Index. And both of these roughly go back to the the 20s, actually. The S&P is going back to ‘26, Small Cap goes to 1928. So we have a long-term data to kind of tell us a little bit, what the differences are in outcomes for investors.
And probably the simplest way to look at it, is the growth of wealth. If you had invested a dollar in the S&P, how would that be different than if you invested a dollar in the small companies? And in fact, I do have this book with me—I tend to have—
It never leaves your side.
Yeah! I know you have a few yourself. And what you see is that going back to 1926, a dollar invested in the S&P 500, would have grown to about $10,900. One dollar increased to 10,900. So let’s just call it almost $11,000, a little less than $11,000, in a large company, a group of stocks, that’s the one asset class that we’ve talked about. If you had taken the exact same dollar over the same time period and invested in the Dimensional US small cap index, based on the matrix book data, the same dollar growth instead of 10,000, or 11,000, would have been about $36,000. So you know, more than three times as much.
So that’s the difference—it’s a difference between investing in large versus small. Over the long run, there has been this, this is what’s called a premium. You can define it in percentages, you can also look at a simple level in growth of wealth. Now, knowing that Small historically has outperformed Large and Value has outperformed Growth, obviously, among these four buckets in the market, the four boxes, you have Large, Small, Value, Growth. Small Value would have both characteristics, it’s both Small and Value, you have both of these premiums. And again, if you look at the matrix book and the index, what you see is that the same dollar, instead of growing to about 11,000 in Large, or 36,000 in Small, the same dollar invested in Small Value would grow to roughly about $92,000.
So that’s the idea, you could invest in the S&P, and get the large company exposure. But if you actually also include small companies in the portfolio—if you pay attention to Value—that gives investors an opportunity to perhaps earn a bigger bang for the buck, but with the caveat that there is a level of risk associated, and I think the biggest risk is not having an advisor who can diversify properly, who can hold the client’s discipline. And I do think that those are key ingredients.
But when looking at data—I don’t want to just say data, but not really kind of refer to, or just leave it like that. Data is important to look at and what the data is really doing is backing up all these intuitive elements that we discussed earlier in the podcast.
Yeah, I think that that’s really helpful. And I think, you know, just in summary, having an investment philosophy that is intuitive, that’s backed by data, really arms investors and gives them the intellectual ammunition they need to stick through the difficult periods. And you know, I’ve seen this in my own career starting in 1984, you know, the ebbs and flows of various asset classes—and gone through lean periods with Value and Small stocks in the past. And it’s always been helpful to have the underpinnings that we discussed earlier to keep you disciplined when it’s really easy to be undisciplined. You know, in that regard, it’s been extremely helpful.
So I just want to say Apollo, thank you so much for spending so much time with with us today discussing what I think is a really critical aspect of portfolio management, and something that should be considered by every investor. Every investor may not want to make those tilts in their portfolio towards smaller value stocks, but at least they need to understand the underpinnings of why they should at least have the opportunity to say no, you know? They need to have the basic information to make intelligent decisions. And I think you’ve done a good job of helping them along here.
You made a great point that maybe is worth emphasizing—that there is no one-size-fits-all. There is no one right answer that fits for everyone. That’s why sitting down with an advisor sitting down with Chas and the team, and really finding out, for my preferences, for my personal situation, for my circumstances, what is the right allocation? And for some people, as you said, it might be that it’s not necessarily tilted more towards Small and Value, but maybe more market neutral. For others, it might be even more. But that it’s not a one size fits all, it’s again, the advisor plays such a crucial role. And every one of the folks you work with, they have this custom allocation based on their specific needs, circumstances, and preferences.
I’m not suggesting at all that everybody should just go pile in Small Value. It’s a very custom allocation that has to be discussed with an advisor. And for some people, as you pointed out, it might be more tilted than others.
That’s right. And as you said earlier in the podcast, there is no free lunch. So you have to be aware of the trade offs—the risk-reward trade offs that you’re making in portfolios and being very thoughtful about it is very critical to your success.
So, Apollo, thanks so much for again for the time, and I’ll look forward to our next conversation.
Me too. Thank you so much for having me. And it’s great fun talking to you always.
Thank you. Have a great day.
You too. Bye bye.
Thank you so much for joining Apollo Lupescu and me today for our discussion of Value and Size and how it impacts or can impact investing and the returns in your portfolio. Please see the show notes for further information and for a transcription of this episode. Thank you very much for listening in. Have a great day.
Apollo Lupescu is a Vice President at Dimensional Fund Advisors, where he started in 2004 after finishing his PhD in economics and finance at the University of California, Santa Barbara.
During his tenure at the firm, Apollo has gained experience in a wide variety of practical subject matters. He was part of the Dimensional Investment Strategies group, worked directly with financial advisors in the Northeast area assisting in the development of their business, managed the internal Client Services team that provides broad analytical support, and then oversaw the firm’s national advisor retirement business. He is currently Dimensional’s “secretary of explaining stuff.” In this role, he frequently presents around the country and the world at financial advisor professional conferences and individual investor events.
Prior to joining Dimensional, Apollo had his own consulting firm, which provided services to the US Department of State and the White House on a variety of projects. His interests in finance and investments led him to teaching engagements at the University of California, Santa Barbara. In addition to his PhD from UCSB, Apollo earned his BA from Michigan State University, where he competed in and coached water polo.
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