Breaking Down Your Asset Allocation: What It Takes to Be Overweight in Small Cap Stocks

In light of academic research indicating that small cap stocks tend to outperform large cap over the long term, we generally advocate that client portfolios be “overweight” in small cap funds.  This does not mean, however, that small cap funds constitute a majority of the equity assets in a client’s portfolio.  For example, as shown in the Morningstar Equity Investment Style box below, a client may have 21 percent of their equity assets in small cap funds (including U.S. and international small growth, small value, and small core or blend funds), and we would still consider them “overweight” in small cap funds or stocks.*  How much does it take, therefore, to be overweight in small cap funds?

According to an August 2014 report by Dimensional Fund Advisors, large cap stocks comprise 70 percent of the total value of U.S. stocks, mid cap stocks comprise 20 percent, and small cap stocks comprise 10 percent.  The numbers are similar for international developed markets (64 percent, 23 percent, and 13 percent, respectively).  Therefore, if a client holds more than 10-13 percent of their equity portfolio in small cap stocks, we would consider them “overweight” in small cap, even though they hold a much larger percentage in mid cap or large cap stocks.

* Note: We consider all accounts (including outside bank accounts, retirement accounts such as 401(k) plans, etc.) when reviewing a client’s overall asset allocation.  This Equity Investment Style appears in the annual review reports that we give to clients, but the percentages represent only the assets under our management.