Thu. Jun 8th, 2023

This time of year is filled with “the best of” lists: movies, books, restaurants, electronics, toys, etc.

My list has just one item.

The best investment lesson of 2022 applies to virtually all investors: You should have at least some percentage of your portfolio in a fund that owns small-cap value stocks.

It doesn’t have to be a lot. As we’ll see, even a small percentage held in small-cap value can make a very significant difference if given enough time.

By itself, this lesson isn’t new. I’ve probably written at least two dozen articles and I’ve co-authored an entire book aimed at pointing out the long-term benefits of small-cap value stocks.

What’s new is a table of data to emphasize my point.

As you probably know, small-cap value stocks represent ownership of relatively small companies that, for a variety of reasons, have stock prices that make them relative bargains.

The “small” in small-cap value means you’re buying companies with huge growth potential. If you own hundreds or even thousands of these companies through a fund, you’re almost certain to be in “on the ground floor” of whatever might become the Microsoft

or Amazon

of the next decade.

The “value” in small-cap value means you’re buying these stocks at a discount price, based on their profits and measured by the price-to-earnings ratio. That’s a smart way to invest.

Over the past 10 years or so, I’ve become increasingly convinced that — at least for most people — simpler portfolios are likely to be more successful than complex ones.

And fortunately, it’s easy to add small-cap value to just about any portfolio. Over time, the rewards of doing so can be substantial without adding much risk. In some cases, a dash of small-cap value comes with virtually no additional risk.

To illustrate this lesson, I’ve put together a simple table, which you’ll find below, showing the long-term historical effects of adding various percentages of U.S. small-cap value to the S&P 500 index

The numbers are based on calendar years 1970 through 2021, a relatively long period that included all sorts of ups and downs in the economy and the market. 

For each combination, the table shows the annualized return and three measures of risk: standard deviation, the largest drawdown (the percentage decline from a peak value to a subsequent bottom) and the worst 12-month period.

Small-cap value percent






Annualized return






Standard deviation






Worst 12 months






Worst drawdown






Source: Merriman Financial Education Foundation

As I discussed in a previous article, only 0.5 percentage points of extra return can add up to $1 million or more over a lifetime in retirement withdrawals and money you can leave to heirs.

Adding just 10% in small-cap value to an S&P 500 portfolio nearly achieves that, boosting the return by 0.4 percentage points. And yet the risk is virtually the same. Boosting the S&P 500 with 20% in small-cap value doubles the additional benefit, with so little extra risk that it probably would never be noticed by most investors.

I’ve used the S&P 500 as the base portfolio, mostly because it’s well-known and easy to understand — and I believe most investors’ equity portfolios at least roughly replicate that index of large U.S. stocks.

But you can add small-cap value to any other investment mix. Doing so, based on everything I know about the past, is likely to increase your long-term returns without adding a lot of risk.

So far we have discussed the rewards of adding small-cap value only in terms of higher returns. Those higher returns mean more money to spend in retirement.

However, my friend and colleague Chris Pedersen, director of research for the Merriman Financial Education Foundation, has concluded that those higher expected returns can provide an additional benefit: They can let retirees safely withdraw a higher percentage of their portfolios.

That’s a double benefit: The higher percentage is applied to the higher portfolio balance.

To see how this might work, consider the following hypothetical scenario.

You and a friend each invest $500 a month into a retirement account for 35 years. Your friend’s money is 100% in the S&P 500; your investments are allocated 80% into the S&P 500 and 20% into small-cap value.

After 35 years you and your friend are ready to retire. Based on the historical annualized returns in Table 1, your friend’s account is worth $2.46 million. Yours is worth $3.05 million.

At a withdrawal rate of 4%, your friend has $98,565 to spend in his first year of retirement; you have $121,904.

That’s a very nice bonus, and you could stop there, knowing you’ll always be able to pick up the check when the two of you go to dinner.

But there’s more. Even if you (wisely) add some fixed-income funds after you retire, if you keep 20% of your equity stake invested in small-cap value, you’ll continue to have higher expected returns in retirement.

If you determined that this higher return would let you safely increase your withdrawals to 4.5%, that would give you $137,142 — an increase of 51% over your friend’s first-year payout.

To most investors, I think that huge extra reward would be well worth putting up with the relatively minor increase in risk.

For readers who want to dig deeper into this whole topic, I’ve recorded a podcast: 10 reasons small-cap value can make you richer.

Richard Buck contributed to this article.

Paul Merriman and Richard Buck are the authors of We’re Talking Millions! 12 Simple Ways to Supercharge Your Retirement. Get your free copy.

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