How to outperform the blue-chip market
Feb 24, 2009
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Stick to the small-fry
If you want to make money for the long term, there is one investment class that is a cut above the rest. It's the small company sector of the stock market.
I could go on and on about why small companies beat big companies, and I might just do that another time. But I am going to take myself and my own convictions right out of the equation and just give you some hard facts about why you should invest in small caps.
There's a guide just out that says it all. It's the Credit Suisse Global Investment Returns Yearbook 2009 [pdf]. The main body of it is written by Elroy Dimson, Paul Marsh and Mike Staunton. These guys know more about the subject of investment returns than anyone on the planet. And what is more important, they are academics and as such are interested only in the pursuit of the unbiased, unvarnished truth.
They also have a very long time perspective – much longer than the typical investor and a million times longer than that of the average City trader. In fact they have measured investment returns all the way back to 1900. And, they have ironed out all the distortions that can be caused by dividend payments, tax and something called 'survivor bias'.
I'll come to the point about small companies in a moment. But first of all here are a few other conclusions from the experts. If your great grandfather had invested £1,000 in the UK stock market in 1900, and he had achieved the exact return of the stock market as a whole that £1,000 would now be worth £224,000 in real terms – i.e. it could buy 224 times more stuff than it could buy in 1900.
Had he invested another £1,000 into Government bonds, those safety-first investments of the totally risk-averse investor, that £1,000 would now be worth £4,500. Yes! Just a pathetic four and half grand! That is the reward for lending your money to the Government so that it can build roads and pay teachers and otherwise fritter it away on the Civil Service, while two hundred and twenty-four grand is the reward for putting your money to work in business.
This strategy could earn you 15% a year
Here is something else you should know. The worst bear market in history was the Wall Street Crash from 1929 to 1931. In that time the world index of shares fell by 54% in real, dollar terms. In this credit crunch-induced bear market the world index has fallen by… 53%.
So the stock market has already fallen as far as it did in 1929-31. This means that it is already discounting a very bad time for the economy indeed. So anything less than Armageddon should see investment at this point handsomely rewarded. In fact Dimson, Marsh, and Staunton say that the likeliest date for the UK stock market to regain its former high is 2014. That implies an annual return of some 15% over the next five years.
So just forget all the daily headlines for a moment and focus on this figure. History shows us that the most likely annual return from the stock market over the next five years is 15%.
Here's why 2.3% is the magic number…
But now look at this. That 15% applies to the stock market as a whole. But history reveals that the return from small UK company shares has beaten the return from large companies by an average of 2.3% EACH YEAR. That makes a massive difference.
In the last century investors in UK shares have boosted the real purchasing power of their savings by 5.1% per year. Over ten years that turns £1,000 into £1,644 and over twenty years that £1,000 becomes £2,704. But if you add to that the 2.3% extra that you get each year from investing in small companies your £1,000 turns into £2,041 after ten years and £4,169 after twenty years.
See the difference? This is why I like small company shares. Of course, there's a place for the boring old Blue Chips. But you should definitely consider using small caps to add some excitement and diversification to your portfolio for long-term capital appreciation.
• This article is taken from Tom Bulford's free daily email, 'Penny Sleuth',
and was first published on Thursday, 19 February, 2009.
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