This list continues ranking assets from least risky (T-bills and bonds) to most risky (U.S. and International Value Stocks).
Large Stocks: U.S. and International: Large U.S. Stocks make up a disproportionate share of Americans’ portfolios. That is partly for marketing reasons, and partly because people tend to invest in what is familiar or what they hear about. People are often surprised to learn that Large U.S. Socks went through two 20-year periods during the last century when they offered no returns after inflation (1929 to the mid-1950’s, and 1966–1982). Even if these stocks feel like a safe bet, it’s risky to have all of your money in this area of the market.
From 1973–2013, the annualized return on Large U.S. Stocks was 10.27%. Large International Stocks’ annualized return was 9.51%. The returns are very similar in the long run, but most people feel more comfortable investing U.S. companies, without realizing that large corporations sometimes change their citizenship. For example, Anheuser-Busch, the largest brewery in the U.S., has been headquartered in Belgium since InBev acquired it in 2008. Similarly, in 2015, U.S. Pharmaceutical giant Pfizer announced plans to merge into Allergan, an Irish company.
The point is that globalization of industry has eliminated some of the distinctions between domestic and foreign-based corporations. We don’t think very differently about Hershey chocolate in the U.S. versus Nestlé chocolate in Switzerland. They’re both big, well-known, publicly traded companies in a competitive market. And over time, both U.S. and International Large Stocks tend to provide higher returns than bonds. Of course, with that higher return also comes a higher degree of volatility, e.g., risk.
Small Stocks: U.S. and International: We see similar performance in Small U.S. Stocks and Small International Stocks. (Their names will likely be unfamiliar to you. The Russell 2000 is the benchmark index for Small U.S. Stocks. The portion of the portfolio focused on these stocks aims to match the returns of the Russell 2000.) Over a 30-year period, Small U.S. Stocks and Small International Stocks have had similar returns: 12.92% and 13.39%, respectively. While you might think Small International Stocks would carry a much higher risk than Small U.S. Stocks, the research shows that adding this asset class to a portfolio actually reduces overall risk, because circumstances affecting stocks in the U.S. are usually not the same circumstances affecting international stocks. In late 2001 and early 2002, Small International Stocks were the ones that resisted the market downturn that affected the U.S.
Value Stocks: U.S. and International: Value stocks are shares of companies that have lower market prices than comparable companies of a similar size. This is usually due to lower-than-expected earnings and/or some underlying distress. As a result, they are a riskier investment, but they carry the potential for some of the highest returns if the company is able to right the ship.
There is risk and reward inherent in distressed companies. Investors are less willing to buy into the stock given the level of risk involved, so the price drops. This builds the degree of risk into the price, as per the Efficient Market Hypothesis.
But asset class is not the only basis of the investment decision. Another important factor to consider is your time horizon. The more time you have, the more risk you may be comfortable taking on since you can wait out economic cycles and downturns. In contrast, if you expect to need the money within five years—for example, to finance a child’s college education—the shorter time horizon would make less risky investments more appropriate.
Over time, you will typically make more money from stocks than from bonds.