How U.S. Small Caps Will Pay for My Daughter’s Education

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I recently opened and funded a 529 college savings plan for my newborn daughter.

Like my 4-year-old son, my daughter is an ideal investment client.

Here’s why…

She has a long-term investment horizon. She doesn’t need to access her funds anytime soon. She trusts my judgment (for now).

And most importantly…

She could not care less about the stock market’s mood swings.

This psychological profile gives me a terrific amount of leeway in building her growing portfolio.

So how am I investing her initial funds?

Well, it turns out that 529 plans come with restrictions – I can’t buy specific stocks. (No “swing for the fences” bets on the next Netflix allowed.)

Instead, I’m told to cobble together a portfolio of index funds representing different asset classes.

But I’ve ignored that conventional wisdom.

Why?

I already know the asset class likely to make the most money between today and 2036.

That’s why I’ve invested 100% of my daughter’s 529 plan in the low-cost Vanguard Small-Cap Index Fund (NAESX).

The “Small Cap Effect”

I’ve written before about the “small cap effect.”

It’s the observation that small cap stocks outperform large cap stocks over the long run.

The University of Chicago’s Eugene Fama and Ken French put this theory to the test.

Their conclusion?

Small cap stocks did generate higher returns over time than large cap stocks… though they did so at the cost of higher volatility.

Why small caps outperform large caps remains unclear. Some analysts argue that small cap stocks are less researched. After all, Wall Street brokerages make little money tracking and trading small stocks.

Others say small companies are just nimbler. They move like speedboats, while larger companies trudge along like oil tankers.

Finally, remember, many of today’s market-dominating tech giants were once small cap stocks.

Apple’s (Nasdaq: AAPL) market cap was around $1.6 billion when it went public in 1980. (Today, it’s the first company to near the $1 trillion mark.)

When Microsoft (Nasdaq: MSFT) went public, its market cap stood at a lowly $780 million.

David Swensen, head of the Yale University endowment, agrees.

Swensen has said that if Yale did not have to fund its operations from its endowment and the trustees were willing to endure an occasional large drawdown, he would only invest Yale’s endowment in U.S. small caps.

The statistics Swensen cites are compelling. Between 1925 and the end of 2006, U.S. small caps rose 15,922-fold.

That compares with, say, a return of 19 times principal for “safe” U.S. government bills over the same time period. (Had you invested in small cap stocks at the bottom of the market in June 1932, you’d have generated a 159,000-fold return.)

 “All In” on U.S. Small Cap Stocks?

Unlike David Swensen, I don’t have to worry about a big drawdown in my daughter’s 529 portfolio.

And the “board of trustees” I report to is myself.

So I’m free to invest all of my daughter’s 529 plan in U.S. small cap stocks.

Does this mean you should do the same?

If you want to maximize your long-term returns, you probably should… but it’s unlikely you’ll stick with this unconventional strategy.

Here’s why…

First, chances are you can’t take the volatility. Small caps collapse the most when markets take a dive. Swensen points out that U.S. small caps fell 95% through the Great Depression.

Second, it’s one thing to know intellectually that between July 1926 and December 2013 U.S. small caps outperformed U.S. large caps by 2.2% per annum.

The challenge is that small caps outperform large caps annually only about half the time.

String together a few years of lagging small cap returns and you’ll be tempted to throw in the towel.

Finally, investing in U.S. small caps is harder than ever.

The financial world is always on the brink of collapse. And the media doom-and-gloomers will get to you eventually.

You’ll end up selling out of your small cap stocks at precisely the wrong time.

So to sum up my daughter’s college savings investment strategy…

Small cap stocks have outperformed large cap stocks in the U.S. going back to 1925. And I’m betting they will continue to do so.

My daughter’s 529 college savings plan will serve as a real-life test of that bet.

Good investing,

Nicholas