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?