Small Stocks = High Return and High Volatility

When I have looked at asset allocation, I have considered a variety of factors to keep my investments balanced. One of these is large/medium/small cap categories of equities. Historically, I have weighted my U.S. stocks heavier in large and medium-cap funds, while maintaining a small percentage for small cap.

This interesting article in Kiplinger’s provides some interesting information on small cap stocks. According to the article, long-term historical data of U.S. stocks from 1926 to 2009 shows that there is a clear difference in returns, anchored by the following groups:

  • Top 10% by size (largest of the large cap companies) returned 9.1% annualized
  • Bottom 10% by size (smallest of the small cap companies) returned 13.1% annualized

Ok, so the small cap stocks returned more. What I found particularly interesting is that when the companies are broken out into deciles based on market capitalization, that returns increase steadily by decile as market caps get smaller. For example:

  • Stocks in the 3rd decile (within the large cap group) returned 10.7% annualized
  • Stocks in the 8th decile (within the small cap group) returned 11.4% annualized.

Clearly, when you take the 4 deciles listed above, it’s evident that average return increases as company size decreases.

That said, on the flipside, these smaller stocks are clearly volatile compared to larger cap stocks.  The range of returns for the top decile vs smallest decile have been as follows:

  • Top Decile: between -10% and +29%
  • Bottom Decile: between -32% and +58%

The small stock volatility gap is quite broad, and a buy-and-hold strategy with such funds would likely be a wild roller coaster ride, to be sure. Nevertheless,  based on the data, it might to be a good move over the long run to allocate at least some percentage of your total portfolio to small company stocks – particularly if you have many more years to retirement. For large investing decisions, you can consult with a professional.

What do you think? Do you have the stomach to invest in the smallest of the small-cap stocks, knowing that the nice returns come with extraordinary volatility?

Comments

  1. says

    I think I would have to invest in a no load mutual fund that focuses on small caps as opposed to buying individual small company stocks. I think there is too much risk an individual stock would go down to zero.

    • Squirrelers says

      Everyday Tips – I agree with you. A no-load fund focusing on small caps would reduce the significant risks of owning just a few small stocks. It would be a better fit for me, as well.

  2. says

    This certainly makes sense, given the fact that small cap stocks have much more room for growth (& consequently higher risks). To get some small cap exposure without going overboard (over-allocating) sounds like a reasonable strategy.

  3. says

    I have some small cap mutual funds. They definitely did worse than the market on the way down. They seem to have recovered at about the same pace as the rest of the market..maybe slightly better. So far, I haven’t seen the big gains but maybe I just need to be a little more patient.

  4. says

    I like Small Cap stocks and invest in them both individually and through mutual funds.

    I have noticed they seem to fall in and out of favor. There is the whole “flight to quality” issue whenever anything bad hits the markets. But, when times are good, they yield much better on average.

  5. says

    Speaking for ourselves only, we invest *and* speculate with part of our assets in natural resource stocks, many of which tend to be by definition penny stocks (under $1) with small share floats, very small market caps, and therefore high volatility. We’ve taken this approach only during the last couple of years, and so far it’s worked out well. But small cap mining stocks are not for everyone. It does take up a lot of time doing research and you need a strong stomach to handle the extreme swings in volatility.

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