Historical Look At Small-Cap Performance In Difficult Periods—Royce
article 05-12-2020

Don’t Trust Your Instincts

Two counterintuitive reasons to invest in small-caps.


Unfortunately, most of us are saddled with poor instincts to be successful investors. This may seem surprising, but there are many activities for which our gray matter is ill suited without long years of training and discipline. Our brains evolved to be very good at trend extrapolation: the habit of expecting tendencies to remain in place. When humans were struggling to survive in our prehistoric years, this was a very useful instinct. A lush and vibrant area was expected to stay that way and be a better place to settle; a cold or arid place was not as suitable. Positive and negative experiences were both generally expected to continue.

However, a successful investor must have the opposite mindset. Positive and negative investment trends always persist for a while, but they also always eventually reverse. Notable investment gains can come from positioning one’s portfolio to benefit from such reversals. Our view is that we have arrived at exactly such a reversal period for small-cap stocks.

One of the most common tendencies for investors is to more heavily weight their portfolios in assets that have delivered attractive returns. However, investors should be mindful of a central tendency for any asset’s returns and to pay particular attention when that asset has delivered higher or lower returns than its long-term average. Perhaps most counterintuitively, caution is warranted when an asset has delivered significantly higher returns than its historical average. In contrast, when an asset has delivered returns at the low end of its historical range, it may be opportunity knocking.

Over the past three years through the end of April, small-caps stocks posted a modestly negative average annualized return of -0.8% And as modest as that negative three-year return is, it’s also very rare. It’s happened in only about 10% of all month-end periods (45 out of 449) since the inception of the Russell 2000 Index in 1978.

The typical wiring in a human mind might react adversely to this negative return, seeing it as unattractive. Yet history suggests exactly the opposite. Subsequent small-cap performance following three-year negative return periods has been unusually strong. As the chart shows, the subsequent average one-year return was 30.1% and the subsequent average three-year return was 18.9%, while the subsequent average five-year return was 16.1%. This performance translated to more than doubling one’s investment for the average five-year period. Instead of being avoided, areas that have delivered subpar returns may be an attractive place to look for future returns.

Average Returns Following Negative Russell 2000 3-Year Return Periods vs. Long-Term Averages
From 12/31/78 through 4/30/20


Past performance is no guarantee of future results.

One can anticipate that readers might object that, while history is all well and good, we have never experienced anything like the current public health crisis and consequent economic shutdown, so how much credence can we give to these historical studies? While it’s true that we have never experienced anything like this situation before, this historical study includes similarly difficult and/or tumultuous periods including double-digit inflation in the early ‘80s, the ’87 Crash, the First Gulf War, the Internet Bubble, 9/11, and the Great Financial Crisis, all of which were also unprecedented before they happened. Historically, markets have demonstrated remarkable resilience when recovering from unprecedented experiences. 

Let’s address one more counterintuitive observation about small-caps, which has to do with what might be called market storms. Investors’ risk aversion understandably rises during market storms. When a severe storm is raging, there’s a fear that it may last for an extended period. But these storms always ultimately pass. For markets, volatility (or the VIX) is a useful measure of the intensity of these storms. For April 2020, the daily VIX averaged 41.5%, a very high level that's in the highest 10% of all months since the inception of the VIX in 1989. 

Does that suggest investors should reduce risk after periods of high volatility? History actually points in the opposite direction. If we look at returns that follow periods of high volatility, we find high returns for small-caps, as the table below shows. The subsequent average one-year return was 28.5% and the subsequent average annualized three-year return was 17.4%. Additionally, small-caps have a tendency to bounce back higher than large-caps after these highly volatile periods. In the periods just described, small-caps beat large-caps in 70% of the subsequent one-year periods and 81% of three-year periods. 

Russell 2000 vs Russell 1000 Monthly Rolling VIX Regimes
Subsequent Average 1-Year Return Periods After VIX 1-Month Average was ≥ 28% from 12/31/89 through 3/31/20 

  Subsequent Average 1-Year Return Subsequent Average Annualized 3-Year Return
Russell 2000 Average 28.5% 17.4%
Russell 1000 Average 21.8% 13.4%
% Of Periods Which Small-Cap Beat Large-Cap 70% 81%

VIX was ≥28% in 37/351 periods.
The table above measures the average returns and spread of the monthly trailing three-year return periods in month where the monthly average three-year VIX level falls within the specified range. The CBOE S&P 500 Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. It is the square root of the risk-neutral expectation of the S&P 500 variance over the next 30 calendar days, and is quoted as an annualized standard deviation. Past performance is no guarantee of future results.

If investors listened to their instincts, they might avoid small-caps after a period of low returns and high volatility. History indicates that investors could pay a price for trusting those often faulty impulses and instead should take a hard look at small-caps now. 

More Small-Cap Perspectives


Important Disclosure Information

Mr. Lipper’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. All indexes referenced are unmanaged and capitalization-weighted. The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 1000 Index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 Index. Index returns include net reinvested dividends and/or interest income.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)



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