Why Small Caps Are Safer Than You Think

Over the past year, we've learned that some companies are too big to fail. But no company is too big to wipe out most, if not all, of its shareholders' investments.

Despite the impressive rally we've seen over the past week or so, many high-profile stocks have only earned back a small fraction of their losses during the bear market. Here are just a few of the most egregious examples:

Stock	Gain Since March 6	1-Year Return
Bank of America (NYSE: BAC  )	148%	(80.4%)
General Motors (NYSE: GM  )	131%	(83.4%)
AIG (NYSE: AIG  )	323%	(96.7%)

Source: Yahoo! Finance.

But the losses go far beyond the names associated most closely with the financial crisis. During 2008, large-cap stocks overall dropped 37% as measured by the S&P 500 index. Meanwhile, the Russell 2000 gauge of small-cap stocks suffered big losses, but not quite as large -- 33.8%.

A smaller drop? That certainly doesn't jibe with what you've heard about small-cap stocks being riskier, does it?

The case against small caps
For years, most investors have considered small companies to be particularly dangerous places for their money. Unlike well-known, blue-chip stocks with an already established customer base, a valuable brand, and the financial resources to weather difficult economic environments, small companies haven't yet proven themselves. Sure, some may grow to supplant their larger competitors, but given how many small businesses fail every year, even those that achieve the success necessary to go public with a respectable market cap seem more vulnerable to hard times.

However, 2008 changed that perspective for good. And while large companies will reel from the implications for a long time to come, small companies are already in position to benefit.

Reaping the rewards of small caps
One reason why large companies got into so much trouble during the economic crisis was that many of them overstepped their traditional bounds. Traditional banks like Wells Fargo's (NYSE: WFC  ) Wachovia found themselves with significant mortgage-related losses. Meanwhile, General Electric (NYSE: GE  ) , which most people wouldn't have thought of as a financial company two years ago, has seen its finance unit take center stage, costing it its AAA credit rating. You can find plenty of similar instances where companies proved vulnerable to the economy's impact on finance-related business segments.

Conventional wisdom would say that if big banks are hurting, smaller banks must be getting massacred. But that's not happening. Smaller banks that you've probably never heard of, including Montana's Glacier Bancorp (Nasdaq: GBCI  ) and West Texas-based First Financial Bankshares (Nasdaq: FFIN  ) , have largely avoided the morass of financial difficulties. Serving rural areas far removed from overheated real estate markets and Wall Street shenanigans, banks like these prove that smaller financial firms have a future in the U.S.

Similarly, other small companies can retool and adjust their strategies far more quickly than their larger counterparts. Their niche products often have more stable demand, and when customers demand new products, it's easier for them to deliver. And because many such companies go unnoticed by professional analysts, you're not playing at an information disadvantage.

Go small, but don't go crazy
Of course, that doesn't mean that you should give up entirely on having large-cap stocks in your portfolio. Often, large caps and small caps don't move in tandem, meaning that owning portions of both will give you diversification that can help smooth the bumps in your net worth over time.

As Motley Fool analyst Tim Hanson noted over the weekend, too much emphasis on buying large-cap stocks simply because companies are large can lead to some ridiculous investment decisions. Similarly, buying into the notion that small caps should make up only 5%-10% of your overall portfolio, while large caps deserve 50% or more just doesn't make sense -- especially now.

Unfortunately, many investors have learned the hard way that bigger stocks aren't always safer. If you're taking on equivalent risk, don't you deserve the bigger rewards that small-cap investing can bring? If you've shied away from small caps because you were afraid of them, now's the time to take a closer look. You may like what you see.

For more on investing in small caps, read about:

• Stocks you simply can't ignore.
• Are these three stocks on Buffett's wish list?
• You can make a million in penny stocks.