What makes small stocks so volatile?
“Breezing Up” By Winslow Homer. Source: National Gallery of Art
Small stocks are generally much more volatile than big stocks. They can jump or drop by up to 20% in a day, while it’s big news if a giant firm like Microsoft or Exxon moves 3%. And their aggregate indices are more volatile as well. Over the past decade, large cap monthly volatility has been around 15%, while small cap volatility has averaged almost 20%.
The extra jumpiness associated with smaller companies adds to their risk, but also adds to their potential return. Since there’s no free lunch, investors demand a higher return to compensate them for their greater risk. But why are small firms so volatile in the first place?
It’s often asserted that small companies have fewer resources. But with venture capital funding and start-up engines like Y-Combinator, this isn’t necessarily the case. Some propose that inexperienced management is more likely to make business gaffs. But many small firms are led by folks who learned their craft in the corporate jungle, and want to work in a smaller arena.
I think small company volatility comes from a more commonplace source: news. News stories that wouldn’t even merit a footnote to a corporate giant can be a big headache or huge source of encouragement to a smaller enterprise. The big pharmaceutical company Merck was hit with by the ransomware bug “WannaCry,” and the stock only moved half a percent. The company already spends over a billion dollars on capital expenditures. A few hundred thousand more on computer security won’t have much effect. But a smaller firm would see a much bigger impact.
News stories are indeterminate. They can come from anywhere. But it takes a really big story to affect a big company, and those aren’t that common. It’s like sailboats at sea. The big storms hurt everyone, while little squalls only hurt smaller craft. But smaller boats can point up into the wind more effectively, and can navigate in waters that are too shallow for big ships.
Hurricane Katrina from space. Source: NASA.
You can’t plan what news is going to hit next. You can try to be ready. If you’re prepared for the ups and downs, small cap stocks can be a good source of returns.
Douglas R. Tengdin, CFA