Is it Time to Abandon Small Caps?
I was recently asked by one of my clients whether I think it still makes sense to hold small cap stocks in his portfolio. This client had heard from an investment manager that now is a good time to shift from small cap to large cap stocks. The investment manager is apparently convinced that small cap stocks will be out of favor relative to large caps for the foreseeable future.
The Arguments in Favor of Holding Small Cap Stocks
There are two good reasons why nearly all investment consultants, including Grand Wealth Management, advise their clients to invest some portion of their equity allocation in small cap stocks. First, small caps are not highly correlated with large caps, meaning they tend to behave differently than their large cap counterparts. Second, small cap stocks have historically outperformed large caps by an average of more than 2 percent annually since 1926 in the United States. Academic studies have found a similar “small cap premium” in other developed and emerging international markets. Most investment consultants agree that the additional return on small caps is “compensation” for the higher level of risk, as they tend to be more volatile than large caps.
Recent Performance of Small Cap Stocks
Small caps have outperformed large caps in seven of the last eight calendar years. This leads some to argue that small caps have “had their run” and that it’s time for the market to favor large caps for a while. But we’ve heard these same arguments being made every year for the past eight years – to the detriment of investors who heeded the advice and shifted out of small cap stocks.
Our Justification for Continued Exposure to Small Cap Stocks
At Grand Wealth Management, we believe that markets work. Companies compete for investment capital, and millions of investors compete to find the most attractive returns. This competition quickly drives prices to fair value, ensuring that no investor can expect greater returns without bearing greater risk. And we believe that no one – not even the shrewdest investment manager – can consistently predict when certain segments of the market will outperform or underperform others.
So when I’m asked if it’s time to abandon small cap stocks – or any other asset class – my response is the same: While I don’t purport to have any special insight beyond what’s already been accounted for by the market, I do believe that over the long haul, small cap stocks will deliver solid returns for our clients and are an integral part of a prudent, well-diversified portfolio.