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Historically, mid-cap and small-cap company stocks have outperformed the market. Correct?

Since I'm not going to touch the money in my 401(k) in over 40 years, wouldn't it make sense to invest exclusively in these types of funds now, and only worry about moving into safer investments decades down the road?

  • Besides this 401k, do you have any other 401k accounts, or any IRAs? – mhoran_psprep Feb 25 '15 at 20:57
  • @mhoran_psprep Yes, a Roth IRA. In that account my allocations are a little more conservative, since I know I can touch my principal whenever I want in case of a super major emergency. – AxiomaticNexus Feb 25 '15 at 21:08
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If the stock market dropped 30%-40% next month, providing you with a rare opportunity to buy stocks at a deep discount, wouldn't you want to have some of your assets in investments other than stocks?

If you don't otherwise have piles of new cash to throw into the market when it significantly tanks, then having some of your portfolio invested elsewhere will enable you to back up the proverbial truck and load up on more stocks while they are on sale.

I'm not advocating active market timing. Rather, the way that long-term investors capitalize on such opportunities is by choosing a portfolio asset allocation that includes some percentage of safer assets (e.g. cash, short term bonds, etc.), permitting the investor to rebalance the portfolio periodically back to target allocations (e.g. 80% stocks, 20% bonds.)

When rebalancing would have you buy stocks, it's usually because they are on sale. Similarly, when rebalancing would have you sell stocks, it's usually because they are overpriced.

So, don't consider "safer investments" strictly as a way to reduce your risk. Rather, they can give you the means to take advantage of market drops, rather than just riding it out when you are already 100% invested in stocks.

I could say a lot more about diversification and risk reduction, but there are plenty of other great questions on the site that you can look through instead.

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    I haven't thought about it that way. Though we should also consider the losses we face from lower return of investments from bonds while we wait years for a market drop. Has it been shown that this strategy has been historically better than just riding it out? – AxiomaticNexus Feb 25 '15 at 23:37
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    Yes. There have been Nobel prizes won about the subject. For an approachable book about asset allocation and why it can be good for your portfolio, and provided you know a little bit of math (you're a developer--you can understand it) then I recommend The Intelligent Asset Allocator by William Bernstein ... but don't take my word for it. Look at the hundred ratings and the reviews. – Chris W. Rea Feb 26 '15 at 1:41
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    I loved this answer. That's exactly how I think about my more conservative investments--a reserve I can drain when stocks are cheap and I want to buy, or replenish when stocks are overpriced and I want to sell. – mwp Feb 26 '15 at 16:58
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    @ChrisW.Rea Just finished the book. I liked a lot the coin tossing example, specially after adding the "uncorrelated assets" part; it really puts things in perspective. – AxiomaticNexus Feb 27 '15 at 0:29
  • @YasmaniLlanes Glad you enjoyed it! – Chris W. Rea Feb 27 '15 at 3:25
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The benefit of the 401K and IRAs are that reallocating and re balancing are easy. They don't want you to move the funds every day, but you are not locked in to your current allocations.

The fact that you mentioned in a comment that you also have a Roth IRA means that you should look at all retirements as a whole.

Look at what options you have in the 401K and also what options you have with the IRA. Then determine the overall allocation between bonds, stocks, international, REIT, etc. Then use the mix of funds in the IRA and 401K to meet that goal.

Asking if the 401K should be small and mid cap only can't be answered without knowing not just your risk tolerances but the total money in the 401K and IRA.

Pick an allocation, map the available funds to that allocation. Rebalance every year. But review the allocation in a few years or after a life event such as: change of job, getting married, having kids, or buying a house.

  • "The fact that you mentioned in a comment that you also have a Roth IRA means that you should look at all retirements as a whole." I don't look at my Roth IRA with as much "retirement strictness" as my 401k. The money in the 401k is untouchable, since it would cost me a lot of money in penalties to withdraw early and I don't like giving away money. On the other hand, the Roth IRA let's me take back what I contributed, which in my eyes makes it less part of all retirements as a whole and more like intermediate to long term funds I could tap (not counting earnings). – AxiomaticNexus Feb 25 '15 at 23:13
  • Then the Roth makes up that segment of your savings. You still have to decide how to invest it/save it. – mhoran_psprep Feb 25 '15 at 23:39
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Can you easily stomach the risk of higher volatility that could come with smaller stocks? How certain are you that the funds wouldn't have any asset bloat that could cause them to become large-cap funds for holding to their winners?

If having your 401(k) balance get chopped in half over a year doesn't give you any pause or hesitation, then you have greater risk tolerance than a lot of people but this is one of those things where living through it could be interesting.

While I wouldn't be against the advice, I would consider caution on whether or not the next 40 years will be exactly like the averages of the past or not.


In response to the comments:

  1. You didn't state the funds so I how I do know you meant index funds specifically? Look at "Fidelity Low-Priced Stock" for a fund that has bloated up in a sense. Could this happen with small-cap funds? Possibly but this is something to note.

  2. If you are just starting to invest now, it is easy to say, "I'll stay the course," and then when things get choppy you may not be as strong as you thought. This is just a warning as I'm not sure you get my meaning here. Imagine that some women may think when having a child, "I don't need any drugs," and then the pain comes and an epidural is demanded because of the different between the hypothetical and the real version. While you may think, "I'll just turn the cheek if you punch me," if I actually just did it out of the blue, how sure are you of not swearing at me for doing it? Really stop and think about this for a moment rather than give an answer that may or may not what you'd really do when the fecal matter hits the oscillator.

  3. Couldn't you just look at what stocks did the best in the last 10 years and just buy those companies? Think carefully about what strategy are you using and why or else you could get tossed around as more than a few things were supposed to be the "sure thing" that turned out to be incorrect like the Dream Team of Long-term Capital Management, the banks that were too big to fail, the Japanese taking over in the late 1980s, etc. There are more than a few times where things started looking one way and ended up quite differently though I wonder if you are aware of this performance chasing that some will do.

  • 1- The funds I'm looking at are VMCIX and VSCIX. I trust that Vanguard sticks to its fund's goal. If it becomes large cap, I can just reallocate. – AxiomaticNexus Feb 25 '15 at 21:00
  • 2- Not in a 401(k). I can't touch this money in decades from now, so seeing it lose half of its value doesn't bother me since I know it will recover and I will be better off in the long run. – AxiomaticNexus Feb 25 '15 at 21:01
  • 3- Couldn't I just keep track of it? If in 10 years from now I notice that large cap stocks start outperforming, I could just reallocate. – AxiomaticNexus Feb 25 '15 at 21:03
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Your initial premise (mid-cap and small-cap company stocks have outperformed the market) is partially correct - they have, over many 40 yr periods, provided higher returns than large caps (or bond funds).

The important thing to consider here is that risk adjusted, the returns from a diversified portfolio are far more robust - with proper asset allocation you and expect high returns and reduce your risk simultaneously.

Imagine this scenario - you decide to stick to small / mid caps for 10 - 15 yrs and move into a more diversified portfolio then. Had you made that decision during a sustained period of poor small cap performance (late 80s or the 40's) you would have lost a boatload of return, as those were periods were small / mids underperformed the market as a whole, and large caps in particular. As an example, from 1946 to 1958 large caps outperformed small every single year. If 2016 were to be the first year of a similar trend, you've done yourself a major disservice.

Since the dot com crash small /mids have outperformed for sure, pretty much every year - but that doesn't mean that they will continue to do so. The reason asset allocation exists is precisely this - over a 40 yr period, no single asset class outperforms a diversified portfolio.

If you attempt to time the market, even if you do so with a multi-decade time horizon in mind, there a good chance that you will do more poorly.

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