[The data on small-cap, mid-cap, and value stock returns in this post were updated in January of 2022.]

If you’re a regular reader you know that I’ve been working for the last couple of months on a series of posts regarding the historical returns of various asset classes.  If you’re not a regular reader, historical returns are one piece of the puzzle in developing a mindful investment portfolio and investing plan that meets your long-term investing goals.

For today’s post, I wanted to look at the historical returns for two so-called investing “factors”.  Factor investing is a strategy that attempts to identify, based on historical data, types of stocks that are prone to superior returns.  Certain factors or combinations of factors are also often pursued to enhance diversification and decrease relative risks.  I’ve written about factor investing before and pointed out some of the assumptions and potential pitfalls behind this strategy.

What’s Factored In

While hundreds of potential investing factors have been identified, many of which are extremely dubious, today I’m going to focus on the two most common factors based on historical U.S. stock data:

• Size – Small capitalization (cap) stocks have often outperformed large-cap stocks
• Value – Stocks with low price per value metrics have often outperformed those with high-value metrics (so-called “growth” stocks).

Most of the time, factor data are presented in terms of the difference between, for example, small-cap and large-cap historical returns.  While that’s useful for describing any excess returns associated with a factor, in this post I’m instead going to evaluate historical returns for small-cap and value stocks just like any other asset class.  If you’re interested, past examples of my historical return evaluations for various asset classes include:

• U.S. large-cap stocks
• U.S. government treasury bonds
• Cash
• U.S. corporate bonds
• Global stocks

In today’s post, I’ll also evaluate mid-cap stocks, which as the name implies are the stocks of companies with capitalizations between small and large-caps.  Mid-caps aren’t commonly identified as a factor per se, but there are many low-cost index funds focused on mid-caps.  And if nothing else, mid-caps represent a “tilt” away from large-cap stocks and toward the classic small-cap factor, which makes them relevant to today’s post.

Historical Returns of Small-Cap Stocks

Small-caps are generally stocks with market capitalizations of less than $2 billion.

When looking at historical returns, the longer the track record available, the better.  Theoretically, you can find small-cap data going back to the early 20th century.  However, Edward Mcquarrie examined the history of the small-cap data from the Center for Research in Security Prices (CRSP) database (one of the most commonly used data sets for factor analyses) and found some surprising problems with the older data.  For one, the CRSP small-cap data from before 1972 exclude 95% of all small-cap stocks known to exist in that period!  And to add insult to injury, most of the remaining 5% were actually former large-cap companies that had fallen on hard times.

In other words, the data on “small caps” before 1972 are of questionable value for predicting small-cap performance in the future.  Consequently, I’m instead using the small-cap data from Portfolio Visualizer that starts in 1972.  This is a pretty short record to use for a historical returns evaluation, but it’s longer than the historical datasets available for some other asset classes.

So, according to Portfolio Visualizer data, the long-term nominal (not inflation-adjusted) annualized return (compound annual growth rate; CAGR) from 1972 to 2021 was:

• 12.0% for U.S. small-cap stocks

As a general comparison, U.S. large-cap stocks returned 11.1% over the same period.  Many factor investors love small-cap stocks because this meager-sounding 1% outperformance can make a huge difference to their final account balance when compounded over many years.

However, the 12.0% annualized return for small-cap stocks is a long-term average, which means that over shorter periods small-cap stock returns diverged substantially from this average.  Here are some additional descriptive statistics for the nominal annual returns from U.S. small-cap stocks back to 1972.

You may be interested in determining annualized U.S. small-cap stock returns between specific years.  Similar to my historical return calculators for stocks, bonds, cash, corporate bonds, and global stocks, this calculator provides annualized U.S. small-cap stock returns (both nominal and inflation-adjusted) between any two dates back to 1972 based on the Portfolio Visualizer data.

Historical Returns of Mid-Cap Stocks

Mid-caps are stocks that generally have a market capitalization between $2 billion to $10 billion.  Mid-cap stock data are also reliable only back to about 1972.  Again based on Portfolio Visualizer data, the long-term nominal (not inflation-adjusted) annualized return (compound annual growth rate; CAGR) from 1972 to 2021 was:

• 12.3% for U.S. mid-cap stocks

This beats the 11.1% annualized return for large-cap stocks in the same period, and it beats small-cap stocks as well.  Given that classic factor analysis focuses on the outperformance of small stocks over large stocks, it’s interesting that middle-of-the-road stocks were the best performer in this period.

And here are the same descriptive statistics for the nominal annual returns of mid-cap stocks going back to 1972.

And here’s a calculator that will provide the annualized return (nominal and inflation-adjusted) for mid-cap stocks between any two years.

Historical Returns for Value Stocks

Value stocks are defined in various ways, depending on the index or company that’s making the determination.  They are usually defined using multiple value metrics such as the ratio of price to things like company book value, earnings, and/or sales.  On this basis, stocks can be segregated into value versus growth styles.  While funds and indices exist that focus on smaller (small and mid-cap) value stocks, I’m presenting data today on large-cap value stocks in particular.

Again, the most reliable dataset for value stocks goes back to about 1972.  Based on Portfolio Visualizer data, the long-term nominal (not inflation-adjusted) annualized return (compound annual growth rate; CAGR) from 1972 to 2021 was:

• 11.4% for U.S. large-cap value stocks

Once again, we can see why many investors prefer value stocks over the broader market.

Here are some additional descriptive statistics for the nominal annual returns of large-cap value stocks going back to 1972.

And here’s a calculator that will provide the annualized return (nominal and inflation-adjusted) for large-cap value stocks between any two years.

Historical Risks for Small-Cap, Mid-Cap, and Value Stocks

Size and value factors have come to prominence in the last 20 years because of the superior historical returns performance that we’ve just seen.  But because higher returns are usually associated with higher risks of losing money, it’s prudent to evaluate the long-term balance of both returns and risks for every investment.  Volatility, as measured by the standard deviation of the routine ups and downs of returns over time, is the most common (but somewhat flawed) measure of investment risk.

In my post on corporate bond returns, I gathered volatility and return data for a wide range of asset classes covering the last couple of decades.  For this post, I’ve added small-cap, mid-cap, and value stocks to this dataset.  While it would be nice to use some of the longer stretches of volatility data available for some assets, using a consistent timeframe (in this case the last 17 years) across all assets ensures that we aren’t including unusual economic events for some assets and ignoring them for others.   Here’s the graph plotting risk versus returns from 2003 to 2020 for multiple asset classes.

The squares represent the actual nominal returns (CAGR) and risks (standard deviation) in this period, and the round dots represent the “theoretical”² or expected relationship between risk and returns for these asset classes.  The two dotted lines represent the best fit relationships for both the theoretical and actual data.

The proximity of the brown and dark red symbols on this chart shows that small-cap and mid-cap stocks in the U.S. have generally met their return and risk expectations over the last 17 years.  In contrast, U.S. value stocks have performed way worse than many would have expected.  The underperformance of value stocks has become so stark recently, that you’ll see headlines questioning whether the idea of value investing is dead for good.

A more mindful view is that, in terms of returns, you would have made a pretty good choice 17 years ago by investing in any one or almost any combination of U.S. stocks including large-cap, small-cap, mid-cap, and/or large-cap value.  And your risks as measured by routine volatility would have been about what you would have expected going into the whole exercise, despite the huge but temporary volatility spike caused by the largely unexpected Great Financial Crisis of 2008.

Conclusions

These data all suggest that U.S. small-cap, mid-cap, and value stocks offer a better return potential than large-cap stocks.  But in the last two decades, the additional returns provided by small-cap and mid-cap stocks come with considerable additional risks, at least as measured by routine volatility.  This is what we would normally expect: the potential for higher returns comes with higher risks.  The classic expectation for value stocks is both somewhat lower volatility (at least theoretically) and higher long-term returns.  But over the last 20 or so years, value stocks haven’t produced much of either.

As I noted in my last post, the problem with these sorts of conclusions is that they’re highly dependent on the timeframe of the assessment.  For example, from 2010 to 2019, U.S. large-cap stocks led the pack in terms of annualized returns:

• Large-caps – 13.4%
• Mid-caps – 12.9%
• Small-caps – 12.7%
• Large-cap value – 12.3%

Further, it’s unlikely that the future will play out exactly like the recent past, whether you’re talking about the markets, the global economy, or just about anything that has a potential impact on stock returns.  In fact, return histories almost always show a cyclical ebb and flow of relative performance when you compare just about any two asset classes or subclasses over the long term. In other words, you can expect superior returns from small-cap or value stocks based on history, but stocks don’t care about your expectations.

1 – The arithmetic average of annual returns differs from annualized returns (CAGR) as discussed more here.

3 – As I noted in my last post, professional investors seem to assume a certain hierarchy of risks and returns among asset classes.  Nonetheless, it’s widely understood that the actual hierarchy of risks or returns in any given period can vary substantially from this theoretical assumption.