Small-cap index funds can be a good investment for investors with a long-term horizon and higher risk tolerance. They offer potential for growth and diversification, but it's important to carefully consider risk, volatility, and market conditions before investing.
One potential advantage of a small cap value tilt is that small cap companies may have more room for growth than larger, more established companies. In addition, because these companies are considered undervalued by the market, they may offer a higher potential return on investment.
High risk: While small-cap companies have a lot of growth potential, they have equal potential to fail. Small-cap stocks are a riskier investment than large-cap stocks. The companies usually have less access to investment capital and are more sensitive to market changes. This makes them a riskier investment.
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On average, small-caps have an advantage when the U.S. economy is in recovery mode. It's typically a great time to invest in small-cap stocks when the economy is rebounding, unemployment rates are decreasing quickly, and businesses are seeing strong earnings growth. Of course, small-cap stocks don't always outperform.
However, between the end of 2008 and the end of 2023 small caps have outperformed, delivering a cumulative return of 521% against 466% for the large cap index over the 15-year period – although past performance should not be seen as a guide to future returns.
Most investors think smaller companies underperform in a recession. In most cases, they are correct. However, what's less well-known is that small caps usually exit recessions quicker than assumed – outperforming large caps. This rebound can begin as early as three months into an economic downturn.
With small-cap mutual funds, always opt to invest for the long Term. Therefore, the minimum period for which you should be investing in small-cap mutual funds is 5-6 years. As mentioned earlier, small-cap mutual funds tend to be very volatile. For example, they may go up and down in the short Term.
The main disadvantage of a small-cap fund is its higher risk profile, making it susceptible to market volatility and economic downturns.
Small companies tend to underperform in recessions and bear markets because they simply don't have the same resources as large companies and aren't industry leaders that can more easily survive unexpected emergencies.
To find an appropriate investment mix for your time horizon, find your age and the corresponding portfolio allocation. A typical mixture could include 60% large-cap (established companies), 20% mid-cap/small-cap (small to medium-sized compa- nies), and 20% international (companies outside the U.S.) stocks.
Since the start of 2023, the S&P 600 small-cap ETF has advanced around 25% as of the time of this writing. That's not bad for a roughly two-year period. But the S&P 500 index (^GSPC -1.54%) is up about 50%, or roughly twice as much. That's a massive outperformance on the part of the large-cap S&P 500 index.
The difference between large-cap, mid-cap, and small-cap mutual funds lies in risk, returns, and liquidity. Mid-cap funds offer moderate volatility and liquidity, small-cap funds are highly volatile with lower liquidity, while large-cap funds provide steady returns with minimal volatility, averaging 7% over five years.
Small-cap funds are riskier than large-cap funds and may not be suitable for everyone. Small-cap companies are more sensitive to market changes and can experience sudden and wide price fluctuations. Small-cap companies are less popular and smaller in size, making their stock less liquid.
Small caps can diversify portfolios and bring higher growth potential — albeit with higher risks. However, the value of small-cap stocks grew more than 10% in the first 10 months of the year, buoyed in part by the Federal Reserve interest rate cut in September.
In July 2024, U.S. small-cap stocks outperformed large-cap stocks after lagging for the first half of the year, driven by a cooler inflation report and improved market sentiment.
In a recession, it's smart to preserve your capital by investing in safer assets, such as bonds, particularly government bonds, which can perform well during economic downturns.
Inflation and small-cap performance through the decades
We found that the MSCI World Small Cap Index outperformed the MSCI World Index by 0.47% per month in periods of low inflation (CPI < 2%) and by only 0.09% in periods of high inflation (CPI > 2%).
We expect small-cap earnings growth could exceed that of large-cap stocks in 2025, aided by easier earnings comparisons.
Historically, small cap stocks have generated higher returns than their larger peers over extended periods. That's because smaller businesses are earlier in their maturation and have more room to grow than larger companies.