The past year was a tumultuous one for small-cap stocks. Investors in small companies had to contend with a lot of volatility. The Russell 2000, the benchmark small-cap index, is up more than 8% in the 12 months through mid-June. But check out the peaks and valleys of small-cap performance — they’re enough to make a skittish investor nauseated.

Experienced investors know what to expect from this asset class. As a reward for their stalwart devotion to small-cap stocks, they have reaped handsome rewards when compared with the returns provided by mid-cap and large-cap stocks.

Small-cap stocks have historically returned 2 percentage points over the broad market returns on an annualized basis, according to William Bernstein, author of “Rational Expectations: Asset Allocation for Investing Adults.”

“That is not chopped liver over 20 years,” he says.

The difference 2 percentage points make over 20 years; Woman: © Lyudmyla Kharlamova/Shutterstock.com; Scale: © Bennyartist /Shutterstock.com;

Over 10 years, the Russell 2000 gained 103%, compared with 75% for the Standard & Poor’s 500 index. As with all stocks, regardless of their size or global location, small-cap stocks swooned in a big way during the 2008 financial crisis.

Despite the added volatility, some experts say that overweighting small-cap stocks can lead to bigger returns over time. Going a step further and putting more focus on small-cap value stocks could boost returns even more over time. As usual, the mileage may vary.

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What are small-cap value stocks?

Small cap refers to the market capitalization of the company. Businesses worth $400 million to $1.8 billion fall into the small-cap category, according to Standard and Poor’s. Market cap is figured by multiplying the price of a stock by the number of shares outstanding.

Value refers to the earnings of the company relative to the stock price. Value stocks generally have a low price-to-earnings ratio. That means the price of the stock is low relative to the earnings of the company. That can happen for a number of reasons, but the basic idea is that the market is undervaluing the stock.

Growth stocks, on the other hand, have a high price-to-earnings ratio. But investors expect such companies to grow quickly. They think their prospects are so good that they will pay a premium to own them.

The formula for the price-to-earnings ratio is the “price of stock divided by a firm’s earning,” says John B. McDermott, associate professor of finance at the Dolan School of Business at Fairfield University in Fairfield, Connecticut.

“With a high price-to-earnings ratio, you’re paying a lot for a dollar of today’s earnings. A low price-to-earnings ratio, you say, ‘I’m not paying a lot — I don’t think it has great growth potential,” he says.

Why does it work if everyone knows?

Usually, when investors know about an asset class’ superior outperformance, the excess returns dry up.

“Everyone knows about it and is investing in it. If your co-investors are bozos, then you are liable to get your hands burned,” Bernstein says.

Yet, the outperformance of small-cap value stocks has persisted despite the fact that everyone and their grandmothers know that small and value do better, over time, than every other asset class.

It comes down to the underlying explanation for the outperformance. There are two theoretical reasons that small value stocks do better over time than large-cap value stocks and other asset classes.

Reason No. 1: Factors and risk

The rewards of an investment are correlated with the relative level of risk the investor assumes. For instance, returns on certificates of deposit are relatively low compared with stocks. You could put your entire net worth into a CD and be relatively certain you would walk away with principal plus interest, as long as insurance levels set by the Federal Deposit Insurance Corp. were observed. Betting the farm on a stock could offer more returns at a higher cost in terms of risk. Exactly how risky it is depends on a few things, including the size of the company and the industry.

“Eugene Fama and Kenneth French called them ‘risk premiums.’ It’s the factors and your exposure to them that explain the vast majority of the differences in risks and returns of a portfolio,” says Larry Swedroe, director of research for Buckingham Asset Management and the BAM Alliance in St. Louis.

Factors include size, value and profitability or quality, in addition to beta. There are other factors as well, such as price or earnings momentum. Each asset class has a particular combination of risk factors. In general, the riskier the asset class, the higher the expected return.

Factors that measure volatility

  • Beta is a measure of the volatility of a stock or fund compared with the overall stock market. A beta of 1 means the stock or fund is expected to move in lock step with the market. Less than 1 means the stock will be less volatile, while more than 1 means the stock will be riskier.

    For example: A beta of 1.2 = 20% riskier than the stock market.

  • Standard deviation measures the dispersion of a stock or fund’s returns around its average, or mean. Think of the bell curve, with the mean at the center and the dispersion of returns on either side. The higher an investment’s standard deviation, the more volatile it is.

    If an investment follows a normal pattern, then its returns would fall within one standard deviation of the mean about 68% of the time and within two standard deviations about 95% of the time.

    Bell curve example

    For example: An investment with an average return of 10% and a standard deviation of 15% means investors can expect returns to fluctuate 15 percentage points above or below the average two-thirds of the time, or 30 percentage points above or below the average 95% of the time.

    That translates to returns between -5% and +25% about 68% of the time, and between -20% and +40% about 95% of the time.

“If you look at the historical data, you see that, in fact, small stocks and value stocks were riskier,” Bernstein says.

“Risk is the probability of having the bad returns in bad times — not just that you can lose money, but you lose money right when the world is going to hell,” he says.

It should be noted that small-cap value stocks do experience extended periods of underperformance as well, which can try the most patient investors.

Reason No. 2: Behavioral explanation

The other explanation for why small-cap value is superior over time hinges on investor behavior. If everyone knows that they’re the best stocks to invest in, why doesn’t everyone go all in on small-cap value stocks? “People just prefer growth stocks,” McDermott says.

Growth companies tend to be in the news, and they seem more glamorous than value stocks, which tend to be established companies that are not as exciting or have been hit with some bad luck or negative perceptions.

“Small growth might be a biotechnology company or biomedical research. People like to talk about them at parties. The behavioral preference is that ‘I want to overweight the GenTechs of the world,’ which would be giving rise to the outperformance of value stocks,” McDermott says.

In other words, less demand by investors of small-cap value stocks results in a lower stock price.

“There are probably aspects of both: rational risk-return economics and behavioral going on simultaneously,” he says.

How to overweight small-cap value stocks

Strategies for overweighting small-cap value stocks can be as simple as adding an extra helping of a small-cap value index fund to your asset allocation. Or, it can get much more math-intensive.

In theory, you could add more risky assets to your portfolio in the form of small-cap value stocks and lower the overall risk.

How does that work?

“If you want to raise the return of your portfolio, you don’t have to raise your equity allocation. You can keep a 50-50 (allocation between stocks and bonds) but add small and value stocks,” says Swedroe. “They’re riskier; at least traditional theory says they are.”

Though no one would kick higher returns out of their portfolio, achieving high returns at the lowest level of risk possible is the ultimate goal.

“If you have two portfolios with the same average annual return, the one with lower volatility will have higher annualized returns,” Swedroe says.

Buckingham Asset Management created a table that shows the risk and return of three portfolios with varying degrees of exposure to small-cap value stocks. The theories and portfolios are covered in depth in the book “Reducing the Risk of Black Swans,” co-authored by Swedroe and Kevin Grogan.

Two of the portfolios with exposure to small-cap value stocks were less volatile, as measured by standard deviation, than the portfolio with only S&P 500 stocks. And their returns were superior to that of the large-cap benchmark. Of course, those two portfolios also contained bonds, which serve as a buffer in times of market turmoil.

Volatility and returns of 3 portfolios, 1970-2013

  Portfolio A Portfolio B Portfolio C
Annualized return/standard deviation 10.4% / 17.6% 11.4% / 12.4% 11.3% / 11%
Years with returns above 15%/below -15% 23/3 18/1 17/0
Years with returns above 20%/below -20% 16/3 11/0 10/0
Years with returns above 30%/below -30% 8/1 2/0 4/0
Best return/worst return 37.6% / -37% 34.4% / -19.2% 32.6% / -10%
Number of years with negative return 9 6 7

Portfolio A: 100% S&P 500

Portfolio B: 30% S&P 500/30% small value/40% 5-year Treasuries

Portfolio C: 40% small value/60% 5-year Treasuries

Source: Buckingham Asset Management

There’s more than one way to skin a cat, as they say. Future returns may not mimic those of the past, but if they’re at all similar, small may beat big, and value may beat growth. The critical ingredient of a strategy that tilts toward factor investing is the ability of the investor to stick with it through the hard times. That’s one reason that a broadly diversified portfolio may be easier for many people to endure.

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