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Stock ETFs: Pros and Cons of Small Value Stocks and Indexes

To be sure, small value stocks are risky little suckers. Even the entire index (available to you in neat ETF form) is more volatile than any conservative investor may feel comfortable with. But as part — a very handsome part — of a diversified portfolio, a small value ETF can be a beautiful thing indeed.

If we knew the past was going to repeat, such as it did in the movie Groundhog Day, there’d be no reason to have anything but small value in your portfolio. But, of course, we don’t know that the past will repeat. Bill Murray’s radio alarm clock may not go off at sunrise.

And the small value premium, like Bill Murray’s hairline, may start to seriously recede. Still, the outperformance of small value has historically been so much greater than that of small growth that you may want to favor a good tilt in the direction of value.

Small value stocks collectively have returned more to investors than have large value stocks or any kind of growth stocks. In fact, the difference in returns has been somewhat staggering: an annualized return of about 14.2 percent over the past 83 years for small value versus 11.1 percent for large value, 8.8 for large growth, and 9.2 for small growth. Compounded over time, the outperformance of small value stocks has been HUGE.

Anywhere from 60 to 75 percent of your total allocation to domestic small cap stocks should be allocated to small value. But no more than that, please. If the value premium disappears or becomes a value discount, you don’t want to be left holding the bag.

Even if small value continues to outperform, having both small value and small growth (along with their bigger cousins, all of which tend to rise and fall in different cycles) will help smooth out some of the inevitable volatility of holding stocks.

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