The Importance of Small

Do small stocks outperform?

Comparison of S&P Small Cap and Large Cap indices. Source: Bloomberg

On its face, this seems like a silly question. Everyone “knows” that small cap stocks outperform. Since 2000, small caps have grown over 4 times, while large cap shares have only doubled. There’s a 5% annuallized difference between the S&P 500 and the S&P 600 small cap index. Over longer time frames this relationship seems to hold up as well. From 1926 to 2015, small cap stocks returned 11.3% per year, while large caps grew 9.9%. There seems to be a “size effect.”

Finance theory supports this assertion. Small stocks are more volatile—they go down more in bear markets and up more in during the good times. And this makes sense. During times of economic distress, small companies are more likely to fail that larger firms. They have fewer resources—human and financial—and so they are less likely to get through hard times.

So small caps are more volatile. And investors require higher levels of returns to assume the additional relative risk—relative to other assets—that small cap stocks entail. The size effect has been well-documented by academic researchers since 1992, when Gene Fama and Ken French published their seminal paper on the factors that affect stock market returns.

Arbitrage Pricing Theory Equation. Source: Fama/French

But Mark Twain once wrote that it’s not what we know that kills us, it’s what we think we are certain of that just isn’t true. Do small caps really outperform? If you eliminate their best years—the first two years of the bull markets that began in 1932, 1942, 1974, and 2002—big stocks do better. This is the ultimate in backward-looking data mining, though. If you take out the late ‘90s, small-caps do better again. Any asset class underperforms if you exclude its best years.

Every investment has its day in the sun. That’s why it’s important to stay diversified—in terms of size, industry, geography, and capital structure. If you have a long-term outlook, a modest allocation to small and mid-cap equities has the potential to increase your returns marginally without adding significantly to the volatility of your portfolio. But be careful how you get started. If you jump in with both feet, you’re likely to get a little wet.

We don’t know the future. The only certainty is that nothing is certain.

Douglas R. Tengdin, CFA

Chief Investment Officer

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