Looking at returns since the 1920’s, small cap stocks have done better than large caps by about two percentage points. This is not to say that they always do better during any given period of time. In fact, there will often be cycles where small caps will beat large caps, then large caps will beat up on small caps for a while. Over long periods of time, however — like 50 years — small caps will win out. So what gives?
Remember that the pricing of securities is all about risk and return. The greater the risk for a given security, the more return investors require before they will purchase them. For stocks, the lower the price relative to the potential earnings, the greater the return when earnings are met. This means small stocks will be priced lower – relative to expected earnings – than will large cap stocks.
Greater risk also means, however, that there is a greater chance that any given small cap company will go out of business than that any given large company will do the same. If there is a downturn in the economy, large companies like GE can sell off divisions, lay people off, and draw from cash reserves to stay alive. They are also able to get loans fairly easily since people expect them to be able to pay them back. Small companies may only make one or two products and just make payroll each month, so a downturn may wipe them out.
Because these stocks are priced for a higher return, a basket of them, over a long period of time, will outperform large cap stocks. The small caps, after all, have a lot more room to expand and grow than do the large caps. It is really difficult for Coal-Cola to double earnings. It is relatively easy for a restaurant franchise just starting out. The trouble is figuring out which stock will become the next giant and which will fizzle out.
To decrease risk, one can buy a whole basket of these small caps, rather than trying to pick individual stocks. This is done by buying a mutual fund that invests in small caps. (Look for names like aggressive growth, small cap or micro cap in the name. Also, check the box which tells the size of stocks and investing strategy (value or growth) in the prospectus for the fund.) You can also purchase an index fund such as the Vanguard Small Cap Index Fund.
This is not to say that you should only have small caps in your portfolio. Because other segments of the market will outperform small caps some of the time, it is good to include some large caps as well. As you get closer to needing the money, and have more money to protect, buying more of the larger companies is wise wince this will decrease the chances of large losses during market downturns, as will diversifying into income assets.
Please contact me via firstname.lastname@example.org or leave a comment.
Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI
Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.