As investors approach retirement, many start dropping small-cap stocks from their portfolios in favor of investments that are considered more of a sure thing. Small caps may be great for growing your portfolio when you’re young, they assert, but once you’re retired you need to use a more conservative strategy. So they begin loading up on government bonds, established companies and other “safe” investments.

But in reality, the higher annualized returns from small-cap stocks can help prolong the life of a retirement portfolio and increase the annual safe withdrawal rate (SWR). Small caps are not just for young people seeking to grow their nest eggs, but also for retirees seeking to prolong their net eggs’ life.

Intelligent stock selection matters a lot in maintaining that safe withdrawal rate, of course. But research by economists and finance experts shows that the payoff in terms of higher returns more than outweighs the slightly higher risks involved.

Research by Eugene Fama and Kenneth French has shown that small-value stocks have produced superior returns. They looked at the real (inflation-adjusted) performance of small-value stocks, large-capitalization stocks and intermediate-term government bonds going all the way back to 1927 and now carried forward to 2013.

The difference was significant: Small-cap stocks averaged a 16.2 percent return, larger stocks 9 percent, and intermediate-term government bonds 2.4 percent. So that’s a 7.2 percent advantage for smaller stocks.

Small-cap stocks are typically more volatile than their large-cap equivalents, which can be unnerving for some investors. But as long as you maintain sufficient diversification in your portfolio, small-cap stocks can be a crucial ingredient in ensuring that your retirement income will be around for as long as you are.

After reviewing the historical record, there is a solid case for overweighting small-cap value stocks in retirement portfolios, even if there are future reductions in the premiums earned over large-company stocks. However, there is still considerable debate about whether small-cap value stocks truly provide excess returns when risks are appropriately recognized.

It’s important to distinguish between assertions made about small cap in general versus small-cap value, since the value category has performed better historically than growth on an absolute and risk-adjusted basis. There are indications that the small-cap category has performed about in line with stocks in general when adjusted for risk.

Larry Swedroe, for one, showed that between 1927 and 2012, small caps outperformed large caps by about 3%, but with virtually identical Sharpe ratios (a ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance). However, a Vanguard study of the period 1927-2004 showed small-cap value earning an average annual return of 15.1% versus 9.9% for growth, with similar standard deviations.

Financial planners have researched the role of the small cap in asset allocation, beginning with a 1997 article by Bill Bengen. His original research on the 4% rule used only large-cap stocks and intermediate-term government bonds, and he later determined that he could improve safe withdrawal rates (SWRs) by adding small-cap stocks to the mix.

Bengen used a small-cap category that included both value and growth and, based on historical data from Ibbotson, showed that SWRs increased from 4.1% to 4.3% by including small-cap stocks. He determined that including 30% small cap in the mix was enough to achieve the 4.3% SWR. Further increases did little to increase the SWR, so he settled on recommending a stock mix that included 30% small cap.

There is something special about small-cap value, and the question is whether its superior performance is likely to continue. Behavioral economists argue that that there is a bias against value stocks that gives rise to the return premium.

Obviously, older investors do have to be more cautious than younger ones, so smart stock selection is paramount. You’ll find the best choices today in my Value Portfolio.

The Road Ahead

What’s going to happen to the stock market in the near term? The market is likely to continue rising until “something” gives, either higher interest rates or lower corporate profits. In other words, that “something” may be unknown but it will be a negative event, whatever it turns out to be. So, risk is high and warning signs are flashing:

1. Stock trading volume is “dead.” Almost nobody is buying and sellers have their hands on the sell button but waiting for a trigger.
2. The largest buyers of stocks are the corporations themselves, which have a notoriously bad record of buying at market tops. The smart money (hedge funds, corporate insiders, and institutional investors) are currently net sellers.
3. Merger & acquisitions (M&A) activity is at a seven-year high. Historically, extremes in M&A are correlated with market tops.
4. Number of initial public offerings (IPOs) in the second quarter was the highest in 14 years and the number of IPOs in week of July 28th is the highest since August 2000.  Companies tend to go public when they think valuations are at their highest.
5. Margin debt is declining, which historically signals increased investor risk aversion and results in a subsequent decline in equity prices.
6. Corporate profit margins are at all-time highs and primed to revert back down to their long-term average level.
7. The Bank for International Settlements stated that stock markets are “euphoric” and “detached from reality” thanks to the unsustainable easy-money policies of global central banks.
8. Based on the Q Ratio (market price divided by asset replacement cost), the market is 80% overvalued.
9. Market cap to GDP ratio of 114.5% is nearly two standard deviations above its mean and is higher than at any other market peak of the past 45 years except the Internet bubble of 2000. 

I’m keeping a close eye on the Federal Reserve; a strong signal from the Fed that it’s time to raise rates could have a huge impact. But for now, it’s too soon to say that this bull market has no more room to run.