Ben Stein How Not to Ruin Your Life

Ray owns and heads up a national financial planning and services company. I often speak for him at his conferences and, yes, in the interest of full disclosure, I get paid for it.

He had a stunning insight when I first met him about the basic dilemma of the middle class American: "You have an immense future liability, paying for your life when you retire. You have to create an asset that matches your liability."

This seems like something that should be obvious, but it is not sufficiently obvious to make anywhere near enough Americans actually create that asset. This is revealed by our pitiful rate of saving as a nation and a people.

But let's say you are that luckiest of persons on the planet, a young American. How do you make sure that you do in fact create that asset you need so desperately? Well, some of you will recall that recently I laid out a model portfolio. If you are on the Internet, you can retrieve it here, and if you are not, how are you reading this?

But when I mentioned that small cap stocks should be part of your portfolio, you might have wondered why. After all, the data is clear that index funds of the S&P 500 and the Dow 30 usually outperform most managed mutual funds. Why not just go with the indices of the largest companies and let those indices take you on your magic carpet ride?

To find out more about this, I consulted my genius money-manager friend and coauthor on several books, Phil DeMuth. I asked him this basic question: If I had taken the roughly $1,500 I got for my bar mitzvah back in late 1957 and invested it in various forms of stocks, what kind of results would I have gotten?

Turning $1,500 Into Millions

Phil quickly came up with the answers, and they were stunning. If I had invested $1,500 in the S&P 500 index stocks starting in 1958 and reinvested dividends up until the end of 2004, I would have roughly $216,000. Not bad at all, and how I wish I had done it.

(This, by the way, is many times the return I would have gotten on real estate -- unless the real estate happened to have oil or gas under it.)

But if I had narrowed my search and bought only the large capitalization value stocks, which would have been the top half of all New York Stock Exchange (NYSE) stocks in capitalization, and the highest third of those in terms of the ratio of book value to market price, my $1,500 would have grown to an astounding $711,000.

This shows the value of buying stocks with high book value to market price ratios over long periods. Just exactly why stocks with high ratios of book value to market price do so much better than the index as a whole is complex. Finance students study it and write papers about it. The basic reason seems to be that they start out cheaper than other stocks and therefore have more room to rise. They may also be covered inadequately by stock analysts; this offers buyers the opportunity to profit from an "inefficiency" in pricing.

But the really stunning piece of news is that if I had put my bar mitzvah money into small cap, high value stocks, I would have gotten a ride into outer space. If, way back in 1958, I had taken the stocks in the bottom half of the NYSE in terms of capitalization and purchased the third of those with the highest ratio of book to market value with the $1,500, today I would be sitting on around $3,567,000.

All or Nothing?

If you want to invest in small cap, high value stocks today, you might want to consider the IWN, iShares Russell 2000 Value Index, or the IJS, iShares S&P SmallCap 600/BARRA Value. They offer similarly impressive long-term results so far, but again, these things can change.

Why are the returns from small cap, high value so great? Again, it's complicated -- and we may not even know for sure. We definitely cannot promise that it will last forever. But it has to do with buying cheap, dusty, overlooked corners of the market. These tend to be the sleepers that pay off over very long periods.

Now, in that case, why not just put all of your money into small cap value? Why bother with anything else? Because small cap tends to have large fluctuations, such as the way they are correcting as I write this, and you might need money when small cap is down. Also, we do not know if the small cap, high value gold mine will continue to play. But we do know enough to say that some small cap -- maybe even smaller than on the S&P, like the Vanguard Small Cap Value VIPERS (VBR) -- belongs in your portfolio if you start young. If you are already more mature, maybe its swings are too much for you. But for those blessed with a long time period for investing, small cap value looks beautiful, indeed.