Don't Trust Your Instincts

Royce Investment Partners: History suggests that investors who shun small-caps after periods of low returns and high volatility could pay a price later on.

    Steve Lipper

    Steve LipperSenior Investment StrategistRoyce Investment Partners

    Unfortunately, most of us are saddled with poor instincts to be successful investors. This may seem surprising, but there are many activities for which our gray matter is ill suited without long years of training and discipline. Our brains evolved to be very good at trend extrapolation: the habit of expecting tendencies to remain in place. When humans were struggling to survive in our prehistoric years, this was a very useful instinct. A lush and vibrant area was expected to stay that way and be a better place to settle; a cold or arid place was not as suitable. Positive and negative experiences were both generally expected to continue.

    However, a successful investor must have the opposite mindset. Positive and negative investment trends always persist for a while, but they also always eventually reverse. Notable investment gains may come from positioning one’s portfolio to benefit from such reversals. Our view is that we have arrived at exactly such a reversal period for small-cap stocks.

    One of the most common tendencies for investors is to more heavily weight their portfolios in assets that have delivered attractive returns. However, investors should be mindful of a central tendency for any asset’s returns and to pay particular attention when that asset has delivered higher or lower returns than its long-term average. Perhaps most counterintuitively, caution is warranted when an asset has delivered significantly higher returns than its historical average. In contrast, when an asset has delivered returns at the low end of its historical range, it may be opportunity knocking.

    Over the past three years through the end of April, small-caps stocks posted a modestly negative average annualized return of -0.8% And as modest as that negative three-year return is, it’s also very rare. It’s happened in only about 10% of all month-end periods (45 out of 449) since the inception of the Russell 2000 Index in 1978.

    The typical wiring in a human mind might react adversely to this negative return, seeing it as unattractive. Yet history suggests exactly the opposite. Subsequent small-cap performance following three-year negative return periods has been unusually strong. As the chart shows, the subsequent average one-year return was 30.1% and the subsequent average three-year return was 18.9%, while the subsequent average five-year return was 16.1%. This performance translated to more than doubling one’s investment for the average five-year period. Instead of being avoided, areas that have delivered subpar returns may be an attractive place to look for future returns.

    Average Returns Following Negative Russell 2000 3-Year Return Periods vs. Long-Term AveragesFrom 12/31/78 through 4/30/20

    Source: Factset, as of 3/31/20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

    One can anticipate that readers might object that, while history is all well and good, we have never experienced anything like the current public health crisis and consequent economic shutdown, so how much credence can we give to these historical studies? While it’s true that we have never experienced anything like this situation before, this historical study includes similarly difficult and/or tumultuous periods including double-digit inflation in the early ‘80s, the ’87 Crash, the First Gulf War, the Internet Bubble, 9/11, and the Great Financial Crisis, all of which were also unprecedented before they happened. Historically, markets have demonstrated remarkable resilience when recovering from unprecedented experiences.

    Let’s address one more counterintuitive observation about small-caps, which has to do with what might be called market storms. Investors’ risk aversion understandably rises during market storms. When a severe storm is raging, there’s a fear that it may last for an extended period. But these storms always ultimately pass. For markets, volatility (or the VIX) is a useful measure of the intensity of these storms. For April 2020, the daily VIX averaged 41.5%, a very high level that's in the highest 10% of all months since the inception of the VIX in 1989.

    Does that suggest investors should reduce risk after periods of high volatility? History actually points in the opposite direction. If we look at returns that follow periods of high volatility, we find high returns for small-caps, as the table below shows. The subsequent average one-year return was 28.5% and the subsequent average annualized three-year return was 17.4%. Additionally, small-caps have a tendency to bounce back higher than large-caps after these highly volatile periods. In the periods just described, small-caps beat large-caps in 70% of the subsequent one-year periods and 81% of three-year periods.

    Russell 2000 vs Russell 1000 Monthly Rolling VIX RegimesSubsequent Average 1-Year Return Periods After VIX 1-Month Average was ≥ 28% from 12/31/89 through 3/31/20

    Source: Factset, as of 3/31/20. VIX was ≥28% in 37/351 periods.The table above measures the average returns and spread of the monthly trailing three-year return periods in month where the monthly average three-year VIX level falls within the specified range. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

    If investors listened to their instincts, they might avoid small-caps after a period of low returns and high volatility. History indicates that investors could pay a price for trusting those often faulty impulses and instead should take a hard look at small-caps now.


    DEFINITIONS

    The 1987 Crash, also called Black Monday, occurred on October 19, 1987 and was a sudden, severe and largely unexpected systemic shock impaired the functioning of the global financial market system, roiling its stability through a stock market crash, along with crashes in the futures and options markets.

    The September 11 attacks (also referred to as 9/11) were a series of four coordinated terrorist attacks by the Islamic terrorist group al-Qaeda against the United States on the morning of Tuesday, September 11, 2001.

    The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices.

    The Great Financial Crisis (GFC), also known as the Great Recession, the financial crisis of 2007–08, global financial crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared

    The tech bubble (also known as the dot-com bubble and the Internet bubble) was a stock market bubble caused by excessive speculation in Internet-related companies in the late 1990s.

    The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

    The Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies.

    WHAT ARE THE RISKS?

    Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

    Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

    U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.