The Three-Factor Model
Another study, conducted by two of the leading academics in the world of finance, Eugene Fama and Ken French (both former students of the aforementioned Nobel laureates), was even more groundbreaking in nature.
Their study, called the Three-Factor Model, teaches us that equity market returns can be summarized in three dimensions. The first is that stocks are riskier than bonds and consequently have greater expected returns. Next, among stocks, relative performance is largely driven by the two remaining dimensions: small cap stocks vs. large cap stocks and value stocks vs. growth stocks. Many economists believe small cap and value stocks outperform their large and growth counterparts because the market rationally discounts their prices to reflect underlying risk. The lower prices give investors greater upside as compensation for bearing this risk.
More specifically, just as the S&P 500 has much higher historical returns than T-Bills (no surprise there...it's really just payment for taking on the risk of owning equities)...the data shows that the same holds true for small stocks vs. large stocks and for value (financially distressed) stocks vs. growth (financially sound) stocks. In each case, owning the riskier stocks (small and value) must reward the investor over time, in order to attract investor money and to compensate the investor for taking the additional risk. (The caveat here is that while the data shows that small and value do outperform over time, the data also shows us that they don't outperform all the time.)
This is a truly seminal study...grounded in academic research, supported by intellectual underpinnings and backed by historical pricing data from the 1920's...the Three Factor Model has changed the way we think about investing.