Recently, some of my clients asked me a very good question: “Why is my portfolio not doing as well as the S&P 500 index? Shouldn’t we invest more in US stocks?”

The answer is very simple. US equity is only one component of their portfolio, and it happened to do the best this year. The best component of the portfolio will always do better than the whole portfolio. That does not mean we should not diversify.

In fact, I hear similar questions all the time. Seven years ago, it was “Why didn’t we invest more in emerging markets? There’s no way the US market will do better than emerging markets.” Five years ago, it was “Why shouldn’t we put everything in gold? All of my friends are investing in gold.” In each case, I had to twist their arms to get them to stay invested in US stocks, and now they are thanking me.

It’s all too human to chase winners because we are driven by a powerful human tendency called the recency effect. Stated simply, it means that we overweight our most recent experience. This is one of many biases discovered by Nobel Prize winner Daniel Kahneman who is recognized as one of the founding fathers of behavioral economics. (The other two are Richard Thaler and Amos Tversky.)

Chasing winners (be it US equity, or emerging markets, or gold) has proven to be a losing strategy over the long run. I wrote an article about that seven years ago but the idea is still very valid today.

The article is based on Black Rock’s twenty year asset class return table. In it, I compare three strategies: momentum vs contrarian vs diversified. With the momentum strategy you always invest in the best performing asset class of the last year; with the contrarian strategy, you always invest in the worst performing asset class of the last year; with the diversified strategy, you just stay diversified and disciplined. Here is the result …

As you can see, the momentum strategy has the highest return volatility (risk) and the lowest return! Go read the article yourself.

Many investors are puzzled by the underperformance of small cap value since May of this year. They ask: “Is it worth being in an asset class that can’t do well in bad times?”

To answer their question, I did a 10-year rolling return comparison between the Fama/French Small Cap Value (SCV) and the S&P 500 index using data from 1931 to 2010. The first 10-year period is 1931 to 1940, the second is 1932 to 1941, and the last is 2001 to 2010. Here is the rolling return chart I got.

Here are the summary statistics:

If you just look at the chart and the statistics, what is there not to like about small cap value? It outperformed the S&P 500 nine out of every ten 10-year periods, usually by a huge margin, and even when it didn’t, it didn’t by a tiny bit.

But alas, small cap value is not for the faint of heart.  In a bear market, it usually falls quicker and harder than large cap.

Think about it, the market is ultimately fair; those investors who can endure more pain in a down market will reap the reward of higher long-term returns.

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