SMI frequently states that your most important investing decision is the "asset allocation" decision. Within the SMI framework, this specifically refers to how you divide your portfolio between stocks and bonds. Different asset classes like stocks and bonds (as well as others such as real estate, precious metals, cash, etc.) provide broad diversification and balance to your portfolio.

But there's another step involved with properly diversifying your holdings. Within your stock and bond allocations, it's wise to further diversify between different types of stocks and bonds. Diversifying among asset classes produces the largest contrasts — the "marching to different drummers" idea we're seeking. But differences within an asset class can matter too. One great example of this is diversifying between the stocks of large companies ("large caps") and small ones ("small caps"). At times, the performance of these two stock types can vary dramatically. By owning both types, you can dampen the volatility of a portfolio and create smoother performance.

Whether small-cap stocks deliver better returns than large-caps is a matter of debate. Much of the long-term stock-market data support this claim; however, skeptics make some good points about the difficulty investors have in actually capturing this higher performance.

(Click table to enlarge)

Fully exploring the details of that debate is beyond the scope of this article. However, the research shown in the table at right supports the idea that better returns are available through small-company stocks. The left column shows the returns of the large-company stocks that comprise the S&P 500 index, the right column shows the returns of roughly the smallest 5% of publicly-traded stocks, while the middle column shows a 50-50 blend of these two types.

We are able to include so many performance periods by using "rolling" data. The first one-year period measures 12 months beginning in January 1950. The second period "rolls forward" one month to begin in February 1950, then March 1950, and so on.

Comparing the average results of the left and right columns clearly shows that small stocks have outperformed large ones over every time period measured. However, the table also makes clear that these higher returns come at the cost of higher risk with small-caps, at least in the short-run. The worst-case result for small-caps was notably worse at the 1-, 3-, and 5-year intervals. Beyond that, the better long-term performance asserts itself and small-caps compare favorably.

Another way of expressing this is that small-caps have been considerably more volatile than large-caps. When the stock market goes up, small-caps go up more. When the stock market falls, small-caps fall more. No one minds when small-caps rise faster, but that greater volatility sure stings when the market falls. Because the long-term direction of the market has been up, this "volatility boost" has helped more than it has hurt. Small stocks aren't better, they're just turbo-charged in whichever direction the market is pointed.

Small stocks in SMI's strategies

Given their stronger long-term performance, it would seem an investor may want to overweight small caps in a portfolio. However, it's important to recognize that their higher volatility may make it harder for investors to stick with their plans. If an investor is more likely to abandon his or her plan during times of market stress because the volatility of the portfolio is too high, that alone is a good reason to question how high a small-cap allocation is truly desirable.

In an effort to balance the benefit of the higher returns available with small-cap stocks against the emotional challenges involved with owning them, SMI has constructed our Just-the-Basics and Upgrading strategies to tilt toward higher small-company stock allocations, but without going overboard.

In Just-the-Basics, we allocate 40% to stocks of large companies, 40% to the stocks of small- to medium-sized companies, and 20% to the stocks of foreign companies. In other words, one-half of the U.S. stock holdings are those of the smaller U.S. companies.

With Upgrading, we have the flexibility to vary the allocations from year to year. In 2013, even when it appears at first glance that our allocations are favoring large-company stocks over smaller ones (see Table 2 on page 171), we are still actually overweighting small-caps relative to the market. Here’s why.

The most prominent measures of “the market” are heavily dominated by large companies. For example, the well-known S&P 500 index, which is often quoted as “the market’s return,” is comprised entirely of large stocks. More importantly, the most representative measure of the entire U.S. stock market is the Wilshire 5000 index. (That’s why we use it as our benchmark for reporting purposes.) It’s comprised of roughly 70% large-company stocks and 30% small- to medium-sized company stocks. So, any allocation to smaller stocks greater than 30% is, by definition, overweighting smaller-company stocks versus the U.S. market.

Consider our recommended allocations this year: 46% to our two large-cap categories, 34% to our two small-cap risk categories, and 20% to foreign. (Let’s leave aside our foreign recommendations for the moment. They will naturally tilt, due to the momentum rankings, toward whichever group — large or small — is performing better at the time.) Looking more closely at that 34% small-cap allocation, we can see that it represents 42.5% of the U.S. stock portion (it’s 34% of the remaining 80%). That means we’re overweighted in small- and mid-caps, even in a year like this one where we “favored” large stocks and reduced our small-cap allocations from 2012. Some years we allocate much more aggressively to small-caps.

Owning small-company stocks isn’t a silver bullet for outperforming the market. Higher costs can diminish the apparent performance of small-cap investing, and there are long periods of time when large companies outperform small companies. For example, between 1995-1999, large companies gained 251% vs. only 116% for small companies.

That said, we think the evidence is compelling enough to tilt our portfolios in the direction of small-company stocks. If you’re following JtB or Upgrading, you’re already doing so — now you know why.