COLUMBUS, Ohio -- Most financial advisers tell people saving for retirement to spread their risk by investing in several types of mutual funds. But an Ohio State University study revealed that relatively volatile small-stock funds are the best bet for people who make steady, periodic contributions in investments for a long period of time.
"Small stock funds are the way to go," said Sherman Hanna, professor of financial management in Ohio State's College of Human Ecology. "In our research, we found that you always come out better with more aggressive stock funds, as long as you have a 20-year time frame before retirement and are a periodic investor."
Hanna conducted the study with doctoral student Peng Chen. It was published in the July 1999 issue of the AAII Journal, the journal of the American Association of Individual Investors.
Most advice given to investors is based on research looking at investing a large chunk of money all at once, with a one-year time frame, Hanna said. But most of today's investors are people who make monthly or biweekly contributions to a retirement or other long-term investment account. Hanna suspected that financial guidance for one type of investor might not be appropriate for another type.
Based on the study's results, Hanna believes directing all new contributions into a small stock index fund would be a wise investment for anyone making steady, periodic contributions into an account they don't expect to draw upon for at least 15 or 20 years.
As the basis for their research, Hanna and Chen drew upon Ibbotson Associates' 1997 Stocks, Bonds, Bills and Inflation Yearbook. The book provides historical data from 1926 through 1996 for six asset categories: small company stocks (often labeled as among the riskiest investments, short of junk bonds), large company stocks, corporate bonds, long-term government bonds, intermediate-term government bonds and 30-day treasury bills. Ibbotson Associates' categories are often used in such research.
Hanna and Chen then put the computer to work. They asked it to figure out what would happen if a person contributed the same percent of income in one or a combination of those funds every year over a long period of time -- anywhere from 10 years to 40 years. They looked at both the average accumulation and the minimum accumulation, or worst-case scenario, for each period.
Surprisingly, diversification among different types of funds did not prove to be the best overall investment choice in the majority of cases, Hanna said. For holding periods 33 years or longer, small stocks always outperformed large stocks. For holding periods of 18 years or more, even those that spanned the Great Depression, small stocks beat large stocks more than 90 percent of the time.
For investing during a shorter time frame, small stocks are riskier than large stocks -- their performance deteriorated more rapidly during their worst periods. However, they often performed as well or better than other investments, Hanna said.
"The common advice is that if you're averse to risk, then you should invest less in stocks," Hanna said. "But after doing this research, I would say you should invest less in stocks only if you're either close to retirement or incredibly averse to risk -- you'd have to be a nervous Nellie. History says you'll be much better off in the long run in small-stock index funds." The small company stocks used in this profile aren't the tiny start-up companies many people think of when they hear "small company," Hanna said. Rather, they include the bottom fifth of stocks in terms of capitalization on the New York Stock Exchange. Most small-cap funds are made up of similar companies, he said.
Based on this study, Hanna recommends that any periodic investor seriously consider putting new contributions into small stock index funds for the long term. A mutual fund provides enough diversification within itself to shield investors from peaks and valleys of any one stock, he said. Also, Hanna recommends index mutual funds -- generic funds that simply mirror a broad market sector -- rather than managed funds, because fund managers can make mistakes just as much as anyone else. "When you put your money in a managed fund, you're really at the mercy of the fund manager," Hanna said.
Hanna emphasized that based on this research, he can't recommend that anyone put a large amount of money all at once into small stock funds. This research only looked at making periodic contributions over a long period of time.
Finally, Hanna recommends that small investors resist the temptation to time the market to follow the adage, "Buy low, sell high."
"If you start jumping in and out of the market, you're going to make mistakes. There are people who get paid a lot of money to try to do that, and even they make mistakes. A better strategy is to just keep putting money in periodically. When the market goes down, don't get nervous and decide to take your money out of the market. Think of it this way: The stocks you're buying just went on sale."
Contact:
Sherman Hanna, 614-292-4584;
Hanna.1@osu.edu
Written by Martha Filipic, 614-292-9833;
Filipic.3@osu.edu