Monday, April 24, 2006

Stock Market Styles Are Very Cyclical

NYC Money has a good article posted on her blog regarding large caps and why the financial industry keeps promoting them. She postulates that the financial industry including writers for financial media really have no idea how to make money in the stock market and so they thereofre just keep repeating the same "advice" everyone else has been giving.

I agree with what she wrote and some of the comments posted there. If money managers and financial writers really wanted investors to achieve the highest returns over the long haul, they would tell them to invest in value and small caps, placing a large amount in small cap value stocks. If one had invested $10,000 in small cap value stocks in 1926 and held them and re-invested the dividends, that investment would have been worth about $1 billion by the end of 2004, as discussed in a previous post I wrote about small-cap outperformance.

She mentioned she doing well in foreign equities and I admit that I myself have been investing in foreign stocks over the past year and have done well. However, if there's one thing I've learned by following the markets and investing for the last 10+ years it is that the stock market tends to be very cyclical. Investing styles tend to do in and out of favor. For most of the 90s, large caps (especially large cap growth) performed very well and may have provided better returns than small caps or foreign stocks. Small caps and mid caps have substantially outperformed large caps since 2000. The tide will eventually turn again, although I don't really know when that will be.

Foreign stocks and emerging markets performed very poorly in the late 80s and during most of the 90s. The problem with a lot of the emerging markets is that the political situations in those countries are frequently unstable. Investors in emerging markets took a bath, for example, (a) in the mid-90s when Mexico's currency collapsed, (b) in the late 90s when the Asian currency crises occurred and Russia devalued its currency, and (c) in or around 2001 when Argentina defaulted on billions of dollars in international loans and its currency collapsed.

The stock markets of foreign developed markets (e.g., in high GDP countries such as Japan or Western Europe) also tended to trail the large cap US stocks in the 90s due to the Japanese stock market crash, although they have certainly provided better returns than U.S. large caps over the past 6 years.

I think that a well-diversified portfolio, such as my Hypothetical Long-Term Portfolio, should include large caps, mid caps, small caps, and foreign developed and emerging markets stocks. In a previous post I posted a useful chart that illustrates the annual returns for various investment styles between 1986 and 2005.

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