Summary

The Long-Term

There is a tremendous amount of industry and academic literature that points to the fact that small stocks have performed better than large over the long-term. The accompanying graph is a common representation of those long-term performance results.

This long-term performance is unquestionable. As the graph shows, a $1 invested in small stocks in July 1963 grew to $639, a compounded return of +12.4%, while that same $1 invested in large stocks only grew to $172 or +9.8% compounded annually. This great long-term success doesn’t tell the whole story!

What is a “Small Stock”?

Before we dig into some additional performance analysis of small and large stocks, let’s first define what is a small and large stock.

The size of a stock is determined by the total value of all its stock. In industry terms this is called “market capitalization” or “market cap” (total number of shares x price per share). For example, to buy every share of stock in Amazon.com would cost $900 billion. On the other hand, to buy every share of stock in the furniture company Ethan Allenwould cost about $600 million.

Amazon is clearly a large stock while Ethan Allen is considered a small stock based upon the following common market cap groupings:

Many large and mega cap companies are household names while there are likely 100’s of small cap stocks you’ve never heard of. It’s these small, and generally lesser known, stocks that have delivered very strong long-term performance that every investor needs to benefit from.

Investment Thesis for Small Stocks

There are several strong arguments for investing in small stocks and explanation as to why they perform better than large stocks including:

These are a handful of very good reasons to own small stocks but investors must recognize that this logical support for small stocks does not always translate into better stock performance.

An entirely different story the last 35 years!

Clearly since the 1960’s, small stocks have performed significantly better than large stocks. This holds true when looking back to the 1920’s as well. But what looks so good over those many decades does NOT look so good the past 35 years! This is the rest of the story for small stocks.

Seldom discussed in the literature is that from nearly the start of the great bull market of the ‘80s, investors have been relatively disappointed owning small stocks as compared to large. As illustrated in the accompanying graph, $1 invested in small stocks in August 1983 has grown to $17 today while the same $1 invested in large stocks has grown to $40!

This performance is unquestionable as well. During the 35 years, large stocks have compounded annually at 11.1% while small stocks have compounded at 8.4%. And not only have small stocks delivered a meaningfully lower return than large stocks over this time, small stocks have continued to have higher risk than large stocks. This is obviously the worst of both worlds for investors.

As is the case for any investment with great long-term performance, there will always be periods of disappointment but, it goes without saying, 35 years is a very long time to test the patience of investors.

Should you give up on small stocks?

NO!!! Small stocks still very much belong in every portfolio. Here’s why:

No “Lost Decade” for small stocks

The 10 years from December 1999 to December 2009 is widely been labeled the “Lost Decade” for U.S. stocks. But that’s not the case for all U.S. stocks. This period is called the Lost Decade because large stocks, when including BOTH price change AND dividends, lost -9% of their value. But during this same period, small stocks gained +41%!

It was a lost decade for large U.S. stocks but certainly not small stocks. Diversification in small stocks dramatically improved the returns of an investor's portfolio during this decade.

Early stage of bull markets

Bull markets are certainly a great time to own stocks but it is often the first year of a bull market, or early stage bull markets, that is among the very best. This is true for both large and small stocks but, as the accompanying table shows, small stocks tend to do much better than large during these periods. For example, following the bear market of 2000 – 2002, small stocks surged +63.0% during the first year of the bull market that followed while large stocks gained +35.1% during the same time.

There are some good reasons why small stocks tend to rally fastest at the start of a new bull market. One is that investors tend to being willing to take more risks in bull markets and will naturally gravitate to smaller stocks initially. Sometimes also small stocks fall more than large stocks during the bear market so there is more room for a rebound as investors go looking for the best opportunities. Regardless of the reasons, the fact is that the performance has been consistent for small stocks at the start of all six of the major bull markets of the past 50+ years. This is the kind of rally investors cannot afford to miss out on!

The tide can shift

It’s been a long 35 years for investors expecting their small stocks to perform better than large. This tide can shift quickly though and could persist for years when it does. Some major proponents of small stocks are hopeful now that maybe this tide may have turned in January 2016 given small stocks are higher by +51% while large stocks are up only +45% during that time. This is a short window of time but does provide hope.

Whether or not the tide is shifting now or not, investors must stay diversified to capture the benefits that all of these investments have to offer without owning too much of any one to avoid undo risk.

What’s it all mean?

Stay diversified! We never know which investment in our portfolio is going to perform the best in the future…that’s one of the reasons we diversify.

Additional Disclosures

Large Stocks: S&P 500
Small Stocks: CRSP1-5 for 6/30/1963 – 8/31/1987, Russell 2000 since 9/30/1987

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Any specific securities or investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own situation before making any investment decision including whether to retain an investment adviser.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions.  Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. This content was created as of the specific date indicated and reflects the author’s views as of that date. Supporting documentation for any claims or statistical information is available upon request.

Past performance is no guarantee of future results.  Any comments about the performance of securities, markets, or indexes and any opinions presented are not to be viewed as indicators of future performance.

Investing involves risk including loss of principal.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. For more information on specific indexes please see full disclosure here.

Any charts, tables, forecasts, etc. contained herein are for illustrative purposes only, may be based upon proprietary research, and are developed through analysis of historical public data.

All corporate names shown above are for illustrative purposes only and are NOT recommendations.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.