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Nov. 18, 2015, 11:15 a.m. EST

Small-cap value is the gold ring of investing

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By Paul A. Merriman

About Paul

Paul Merriman is committed to educating people of all ages to get the most from their retirement investments. Founder of Merriman Wealth Management, a Seattle-based investment advisory firm, he is the author of numerous books on investing: "Financial Fitness Forever," "Live It Up Without Outliving Your Money," and the new "How To Invest" series, free at his website:  "How To Invest" series: "First Time Investor," "Get Smart or Get Screwed: How to Select the Best and Get the Most from Your Financial Advisor" and "101 Investment Decisions Guaranteed to Change Your Financial Future." In his retirement, Paul writes a weekly column at MarketWatch and continues his weekly podcast, Sound Investing, which was recognized by Money magazine as "the best Money Podcast in 2008". He is president of The Merriman Financial Education Foundation and all profits from the sale of his books are used to advance financial literacy. His recommendations for portfolios of Vanguard funds, Fidelity funds and ETFs, podcasts, articles and books are available at paulmerriman.com. Follow Paul on Twitter @SavvyInvestorPM.

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I think I'm a fairly cautious, conservative investor. But today I'm here to talk about the most potent part of my portfolio; it's so powerful that sometimes I wonder if I should own more of it.

I'm talking about small-cap value stocks. All the evidence points to one conclusion: For long-term investors, this is the surest way to "grab the gold ring" of investing.

This is the third part of a series on compound interest, which was famously cited by Einstein as one of the wonders of the world. For worthwhile background, you may want to read the first and second columns in the series.

As we saw in the tables in that first piece, compound interest works its magic best when it has lots of time. And small-cap value stocks are ideally suited to investors who can take a long-term view.

Before I get into details, let me say this about small-cap value as an asset class: If in the future these stocks can produce even 75% of their long-term returns since 1928, a modest investment in them can change people's lives.

For quick review, small-cap value stocks combine the characteristics of stocks of relatively smaller companies (which in many cases, at least in theory, have huge growth potential) with the characteristics of value companies (which typically sell at what could be viewed as bargain prices).

As an asset class, small-cap stocks have a long track record of beating larger-cap stocks. Ditto for value stocks vs. more popular growth stocks. Put these two classes together and you have smaller companies that look like bargains.

What does history say?

To evaluate past performance, the S&P 500 Index is a common benchmark, so let's start there.

That index, which tracks the 500 largest-cap stocks in the United States, was formally created in March 1957. Since then, the index has compounded at 10.1%, through the end of 2014. Academic researchers have simulated the S&P 500 back to 1928, finding its hypothetical performance to be 10.1% before 1957. (Fine print: These figures don't take into account inflation, taxes or any management costs.)

With that 88-year history, it may be reasonable to expect future 10% returns for the S&P 500. But I'm uneasy with just making that assumption. For example, in the 15 years that ended Oct. 31, 2015, the index grew at only 4.4%.

Whatever future returns investors get from the S&P 500 Index, I am quite sure that over the long haul they will get more from small-cap value stocks.

Academic researchers say the small-cap premium should be two percentage points above the S&P 500, and the value premium should be another three percentage points.

If that is correct, then small-cap value stocks could produce returns of about 9% in an environment in which the S&P 500 gets 4.4%. In a single year, that would double the benchmark index's performance. But compounded over long periods, the difference could be very significant.

For example, in 15 years, $1,000 grows to $1,908 at 4.4%, vs. $3,642 at 9%. (That difference is bigger than it looks; a gain of $908 vs. a gain of $2,642.)

That's theory. In fact, over the past 15 years the small-cap value return was more than six percentages points higher than that of the S&P 500.

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