There's a simple maxim in investing: "The trend is your friend." For those who've taken on the greater risk of investing in shares of small companies, a decade of outperformance compared to larger-company stocks has been friendly indeed.
But like houseguests who worry that they've overstayed their welcome, small-cap investors have gotten nervous that those years of crushing better-known, more popular big stocks are coming to an end. That raises a simple question: Is it time to get out of small-cap stocks, or are there places you can invest that should thrive no matter what happens?
Looking at history
This month's new issue of Rule Your Retirement takes a close look at choosing between small-cap and large-cap stocks right now. Everyone knows about the lost decade for stocks, in which major market indexes like the Dow Jones Industrials (INDEX: ^DJI) have essentially gone nowhere. But when you look at broad measures of small-cap stocks, you can see that the 2000s weren't a lost decade at all. The Russell 2000 index of small caps actually rose 6.5% annually over the past 10 years, beating the S&P 500's average annual return by nearly 4 percentage points. A 6.5% return may not be what stock investors hope for, but it's a far cry from making nothing on your money.
If you think that level of outperformance is particularly special, think again. Over the past 85 years, through good times and bad, small caps have beaten large caps by more than 2 percentage points. Put another way: $1 invested in small caps back in 1926 would now be worth almost $16,500, versus just over $3,000 for $1 invested in large caps.
Ready for a fall
This past month, though, investors have remembered the other side of the risk/reward equation. The Russell 2000 was down almost 9% in August, compared to less than a 6% decline for the S&P 500 and just over 4% for the megacap-heavy Dow. Several promising small caps -- including Star Scientific (Nasdaq: CIGX ) , Solazyme (Nasdaq: SZYM ) , and Glu Mobile (Nasdaq: GLUU ) -- saw losses in the neighborhood of 40% in just one month. By contrast, none of the members of the large-cap S&P 500 lost close to 40%.
Small-cap stocks are definitely more volatile than their larger peers. That's because their prospects are always less certain; while a bad spell can put a crimp in a big company's financials for a while, it takes a lot more to threaten its very survival. By contrast, small caps face potentially catastrophic challenges all the time.
In general, returns for small caps and large caps have moved in cycles. Given the huge interest in dividend-paying stocks lately, large caps could well have their time in the sun for the foreseeable future. Big companies are much more likely to pay healthy dividends than small ones, since growing businesses typically need to plow as much of their income as possible back into expansion rather than returning it to shareholders.
However, as Rule Your Retirement's interview with several Fool analysts describes in more detail, sticking with companies that have strong fundamentals is a winning strategy whether you're talking about large caps or small caps. For instance, some of the mutual funds that Fool fund expert Amanda Kish follows in the small-cap realm have taken different paths toward trying to make the most of the current environment, including stocks ranging from Unisys and regional bank First Niagara Financial (Nasdaq: FNFG ) to small miners Endeavour Silver (NYSE: EXK ) and US Gold (NYSE: UXG ) .
There's a whole lot more in the newest edition of Rule Your Retirement, including several stock recommendations from other Fool newsletter services. With a free 30-day trial subscription, you can get full access to the entire discussion along with a host of other valuable resources.
In the end, it's not very important whether the broad small-cap market indexes can keep outperforming their large-cap counterparts. As long as the small-cap and large-cap stocks you pick do well, you'll be prepared to stay in the financial sun for years to come.