SMALLER-COMPANY stocks have historically outperformed shares of larger corporations. For academics, this outperformance wasn’t, by itself, surprising. Small stocks are more volatile than large stocks, so theory suggests they ought to compensate investors with higher returns. Instead, academics were intrigued because this outperformance was greater than could be explained by small stocks’ higher volatility, as measured by beta.
The small-cap effect was detailed in a 1981 academic paper by Rolf W. Banz, then at Northwestern University (“The Relationship Between Return and Market Value of Common Stocks,”

SINCE THE EARLY 2000s, Wall Street has been tossing around terms like smart beta, factor investing and fundamental indexing. What’s this all about? Think about the money-management business from Wall Street’s perspective.
Actively managing portfolios is lucrative for financial firms. But many investors have wised up to their poor performance, prompting them to buy index funds instead. Problem is, index funds aren’t nearly as profitable for Wall Street. What to do? Wall Street’s answer: Find a way to make more money off indexing by offering index-like funds that hold out the promise of market-beating returns.

THE EFFICIENT MARKET hypothesis suggests that investments are properly priced most of the time, so you’re unlikely to earn superior long-run returns by trying to identify market-beating stocks. This insight, coupled with ample evidence that most professional money managers don’t beat the market, has led many investors to abandon actively managed funds. Instead, these investors have sought to capture the market’s return at the lowest possible cost by buying market-tracking index funds.
What if you want to earn more than the market is delivering?

MANY INVESTORS HAVE an enduring belief in good old-fashioned stock-picking. The hope: If they invest with a collection of skilled mutual fund managers who each have a laser-like focus on one part of the market, they can earn above-average returns.
This approach has led to “style box” investing. Investors might buy a selection of U.S. stock funds that focus on large-capitalization, mid-cap and small-cap stocks. Within these three size ranges, they might purchase a top-rated growth fund,

EXTREME EVENTS HAPPEN more frequently than we imagine—including in the financial world. Think about recent decades. We had the stunning stock market rally of the late 1990s and the subsequent stunning decline, especially among technology stocks. We had the housing mania that peaked in mid-2006 and the grueling bust that followed. We had the financial crisis of 2008. We’ve had 2020-22 global pandemic. In his 2007 book The Black Swan, Nassim Nicholas Taleb highlighted how the supposedly improbable occurs with surprising frequency—and yet folks are shocked every time.

WHEN YOU LOOK AT charts of long-run stock returns, the road to wealth seems obvious: You want to own shares during bull markets and sidestep those nasty market declines. Yet that has proven extraordinarily difficult to do. Stock market gains and losses tend to occur in short bursts, so it’s all too easy for market timers to be caught flat-footed. While market timing was popular decades ago, today money managers typically stay fully invested in the market,

STOCK PRICES SHOULD climb with the growth in corporate earnings per share. What if we do better than that, thanks to rising price-earnings multiples? We may discover that we’re borrowing from the future.
As our portfolios grow fatter, that might not seem so bad. But remember, richer valuations mean future returns will likely be lower, plus any new dollars invested will buy shares at those higher valuations. In fact, as discussed elsewhere, those still saving for retirement should probably pray for lousy returns.

PREDICTING SHORT-TERM stock market returns is impossible. Even forecasting long-run returns is tough to do with any precision. Still, it’s important to have some sense for what you might earn over the next 10 years, so you don’t save too little or spend too much.
Where to begin? Don’t simply extrapolate recent returns or rely on long-run historical averages. Instead, consider stock market returns in terms of three components: the dividend yield, earnings growth and the price put on those earnings,

IF YOU HAD BOUGHT U.S. stocks at the start of 1920, you would have paid around 10 trailing 12-month reported earnings and collected an initial dividend yield of some 6%.
In the years that followed, both the market and valuations fluctuated widely, with shares posting healthy gains in the 1920s, suffering mightily in the 1930s, bouncing back in the 1940s, roaring in the 1950s, losing steam in the 1960s and struggling through the 1970s.

NAMED AFTER RENOWNED economist James Tobin, Tobin’s Q compares the stock market’s total value to the value of corporate assets. This might sound suspiciously like price-to-book value. But book value reflects the value at which assets are carried on a corporation’s books, while Tobin’s Q looks at corporate assets using current values.
This number is available every three months, compliments of the Federal Reserve. The easiest way to track Tobin’s Q is to head to the Federal Reserve Bank of St.

IF YOU OPEN a company’s annual report and turn to the page showing its balance sheet, you’ll see something called stockholder’s equity, which is the value of the company’s assets minus its liabilities. Stockholder’s equity reflects the amount investors have put into the company through stock offerings and reinvested earnings—and how much they might receive if the company were liquidated and all liabilities paid off.
Investors will sometimes take stockholder’s equity, figure out this “book value” on a per-share basis,

MANY COMPANIES DON’T pay dividends, so looking at dividend yields won’t necessarily tell you whether one stock is better value than another. But dividend yields can be useful in gauging how expensive the overall market is.
The S&P 500’s dividend yield has been trending lower since 1982’s market trough, though it isn’t simply because of rising share prices. Rather, part of the reason is that companies have instead been using their spare cash to buy back their own shares.

STOCK INVESTORS OFTEN grow more enthused as share prices climb, which isn’t rational. After all, shoppers don’t rush enthusiastically to the department store the day after the sale ends and prices go back up.
One possible solution: Think like a bond investor. If bond yields drop from 4% to 3%, bond buyers immediately grasp that their nominal return will be lower. Similarly, stock investors might feel less cheery about rising share prices if they focus on earnings yields,

BECAUSE STANDARD price-earnings ratios can be misleading, some investors rely on cyclically adjusted price-earnings ratios, or CAPE, a measure developed by Yale University professor Robert Shiller and fellow economist John Y. Campbell. CAPE is often referred to as the Shiller P/E.
The Shiller P/E is based on an average of reported earnings for the past 10 years, with earnings from earlier years adjusted upward to reflect inflation. This averaging has the benefit of smoothing out earnings,

HOW MUCH YOU MAKE as a stock market investor depends on how fast earnings per share grow at the companies you own and on how much you collect in dividends. But it also depends on the price you pay. How can you gauge how expensive stocks are? Probably the most popular measure is the price-earnings ratio, which is a company’s stock price divided by its earnings per share. Suppose you have a $34 stock with earnings per share of $2 for the past 12 months.