The recent carnage in the stock market has a lot of younger and more aggressive investors rethinking their portfolios, so I thought that it would be useful to talk about a better and safer way to beat the stock market. Many investors assume that you have to pick winners to beat the market, but you are actually more likely to get higher returns with a diversified approach.
While you do have to take some additional short-term risks to get higher long-term returns, more risk does not always equal more reward. Placing all of your money into a handful of high-flying tech stocks is extremely risky and has very unpredictable results. Netflix and Facebook did extraordinarily well in the years leading up to 2018, but they both fell about 25% later in the year. Will they come back? The truth is that we do not know. 1990s tech stars like Cisco and Dell eventually fell, and they still haven't come back.
It turns out that there is a more predictable way to increase rewards with risk. Since most people try to pick the best big growth stocks, small undervalued companies have to offer more to attract investors. Small cap value stocks produced an average return of 15.9% per year between 1971 and 2017, while the S&P 500 averaged only 10.5%. Those large-cap growth stocks that the media loves to talk about? They returned just 10.3% per year on average.
There are some drawbacks to small-cap value stocks. You often face more volatility and larger losses during corrections and bear markets. The other limitation is that individual undervalued small companies are much more likely to go bankrupt, so investing in a diversified small-cap value fund is dramatically safer than holding particular stocks.
It is possible to capture most of the higher returns of small-cap value stocks while lowering risk when you diversify with gold. Intuitively, gold stands to gain when small companies are under pressure because gold provides complete protection from bankruptcy. As a practical matter, a portfolio split 50-50 between gold and small-cap value stocks would have returned 13.4% per year between 1971 and 2017 compared to 10.5% for the S&P 500. Even better, the largest annual loss for the 50-50 gold and small-cap value portfolio was still less than 15% in 2008. The S&P 500 fell by 37% that same year.
If you still want to beat the market but also want to lower risk, then a portfolio of 50% gold and 50% small cap value stocks has been an extremely effective strategy. This is different from the approach that most people take to beating the market, but most of them are not very successful. If you want better results, then something different is exactly what you need.