The Best 401(k) Investments: Small-Cap Value Funds

From 1926 through 2019, small-cap value stocks have delivered investment returns of 12.8% annualized. Even from 1990 through the present, the results are still an astounding 11.4% annualized. The reason for small-cap outperformance over the long haul is that a few companies in a small-cap index today will become the mega-cap stock of tomorrow, and a whole lot of money gets made by owning a small little piece of the companies that grew from small to large.

For instance, the T. Rowe Price New Horizons Fund has delivered 11.79% annual returns since its inception on June 3, 1960. A $3,400 investment when the fund opened, which is the purchasing power equivalent of making a $10,000 investment today, would be worth over $3.5 million today. An important reason why that fund historically outperformed is that it purchased Wal-Mart stock in the late 1970s and held onto it through the early 1990s. Wal-Mart was growing at a 30% clip, and became the largest holding in the fund, and therefore carried the fund to outperformance.

In fact, the company sold its stake in Wal-Mart in 1991 because it had grown so big that the management team for the New Horizons Fund thought it was breaking the spirit of being a small-cap fund by owning the stake in a mega-cap retailer. After Wal-Mart continued to be a super compounded throughout the 1990s, T. Rowe Price wisely amended its prospectuses to give management teams the authority to contain owning shares in a small-cap company that becomes a large-cap firm.

My own view is that investors should be looking for a fund that closely resembles the Vanguard Small-Cap Value Index Fund (VISVX) when perusing their 401(k) offerings. It is an easy fund to neglect, as its performance since inception has only been 8.36%. The reason for this is that 1998 was a year in which small-cap stocks were trading at 32x earnings, one of the highest valuations ever for a small-cap index, so the starting valuation at the time of the fund’s inception does not accurately capture the high-quality of the firm’s own holdings. The Vanguard Small-Cap Value Index Fund captures the same methodology that resulted in 12.8% annual returns from 1926 through the present.

Since Vanguard does not engage in revenue-sharing kickback arrangements with plan providers, these Vanguard index funds are not as commonly featured in company 401(k) plan offerings as they should be. Still, most employees with 401(k) plans have some type of small-cap value index fund among the palette of offerings, and historically, these are the funds that lead to the greatest returns.

The caveat, and there is always a caveat, is that small-cap value funds can sometimes have periods of miserable performance. Between 1926 and 2019, there were four instances when the value of a small-cap index declined by 50% or more, and there were four separate instances of declines greater than 30% but less than 50%.

If you spend a decade or two of your life building up a $250,000 position in a small-cap value fund in your 401(k), the historical record suggests that a day will come when that balance is reduced to $125,000-$160,000. If you sell at that low point, you can wipe out literally a decade or more of investing in a single moment of panic.

Knowing your risk tolerance is huge. My answer to this dilemma is to regularly maintain 10-20% of your wealth in the form of ready, accessible cash so that you will experience less volatility during recessionary periods and also you can play offense by accumulating assets on the cheap. If someone is sitting on $80,000 in a money market fund at the time that the small-cap value index falls from $250,000 to $160,000, putting $35,000 into the small-cap value index while the price is down may prove to be a wise way to turbo-charge one’s wealth and to manage one’s emotions in response to the inevitable market declines that are part of investing.

For those who are ruthless about optimizing their household’s finances, investing in small-cap value funds in your 401(k) is on the list of intelligent behavior because you are investing in an asset with historical attributes that are conducive to outperformance while also investing within the context of a 401(k) that has certain protections against creditors and claimants in the event of you experience some financial crisis or bankruptcy. The risk is that you have to be steadfast in your commitment to small-cap funds, as an untimely sale could leave you in the position of having nothing to show for years of hard work and savings.

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