USA Today – Low inflation has made food and gas more affordable during the recession, but there’s a downside:  Social Security beneficiaries probably won’t get a raise next year, and the IRS may reduce the amount workers can contribute to their 401(k) plans.

The IRS will announce 2010 contribution limits for 401(k) plans in October, based on a formula tied to the inflation rate in the third quarter vs. the year-ago quarter.  For 2009, most workers can contribute up to $16,500 to their 401(k) plans, plus an additional $5,500 if they’re 50 or older.

Unless inflation picks up in August and September, the IRS could be forced to reduce the cutoff to $16,000 in 2010, according to an analysis by Mercer, a human resources consultant.  The threshold for catch-up contributions could be reduced to $5,000.  This would mark the first time the IRS has reduced 401(k) contribution limits.

Read the full article here.

When my colleagues and I discuss the foundation elements of our investing philosophy to new clients, the topic of value investing is one that quickly enters the conversation.

A simple way to describe value investing is trying to buy a dollar worth of something for 50 cents.  Basically you’re shopping the market looking for bargains.  Two names in the value investing space you probably recognize are Warren Buffett and John Templeton. 

So how do we help our clients become value investors?

We hire value mutual fund portfolio managers who basically don’t know or care what the market is going to do over the short term.  They’re looking to buy quality businesses at a cheap price so it’s no different than you or I buying winter coats during the summer. 

But what about growth?  Do we ignore that?

Of course not. 

While in most cases our investment portfolios will be weighted toward value stocks we will maintain growth positions for the diversification.  However, over long term periods value tends to outperform growth significantly. 

Here’s Buffett’s take on the value/growth debate:

Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term “value investing” is redundant.  What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid?  Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation.

But the key point for you is not to overwhelm yourself with owning the right mix of growth and value.  Your focus should be to avoid the insidious force of purchasing power confiscation.  And your best defense against this is by spreading your capital across ownership positions. 

Nobody I know and nobody you know has the slightest clue which areas of the market will deliver the best returns over the next year or two.  It is for that reason I sleep well having my assets spread broadly across the equity spectrum. 

It is my hope that you are doing the same.

Small cap stocks can move differently at different times than large cap stocks. If you look at the past 83 years, small caps have averaged 11.7% while large caps have averaged 9.6%.  But the cost for this greater return is heightened volatility. 

One reason we want to overweight small caps in a portfolio coming out of a recession is that they often move faster than much larger capitalization stocks. 

Why?

For starters, small caps are more flexible as they can cut back or expand quicker in addition to not carrying as much leverage. 

Basically when we are putting more money into small caps, it’s a beta play.  Beta is how quickly an investment moves versus an index.  On the way out of a recession we want something that moves faster; which small caps tend to do.

MAJOR PROBLEM:  In many portfolios of new clients that we review and in most 401k plans we see severe weakness in terms of small cap exposure.  In some 401k plans, a small cap option isn’t even available. 

A poor choice in our opinion. 

But it does take more work to seek out quality small cap portfolios because an ideal portfolio would be one that doesn’t have a huge amount assets because liquidity and trading volume are issues in this space.  You can’t put a billion dollars into a small company without detrimental consequences.

Small cap portfolios will also close their portfolios after they’ve reached a certain size but if you are already a shareholder in a small cap fund, this is a good thing.  You don’t want the fund continuing to take in more and more new money. 

Lesson of the Day:  Regardless if you are underweight or overweight, an investor would be wise to consistently maintain a slice of their portfolio allocated to small cap mutual funds simply due to the extra layer of diversification.