When everything in the financial world seems uncertain, the temptation is to invest in only the most secure of companies. But if you give in to that temptation and ignore all but the largest stocks you can find, you'll miss out on some strong stocks -- and that could add up to hundreds of thousands of dollars of lost gains by the time you retire.
Keeping it small
In this month's brand new issue of the Fool's Rule Your Retirement newsletter, which is available this afternoon at 4 p.m. EST, Foolish retirement expert and financial planner Robert Brokamp reminds his subscribers that size really does matter when it comes to investing. Citing figures from Ibbotson, Brokamp notes that over the long run, small-cap stocks have outperformed their large-cap counterparts by more than 2 percentage points. That may not sound like much, but over 20 years, it makes a difference of more than $300,000 on an initial retirement nest egg of $100,000.
The problem, though, is that small caps don't always do better than large caps. Last year, for instance, the Russell 2000 index lost more than 4%, compared with a 2% gain for the S&P 500.
Perhaps more importantly, small caps appear fraught with risk. For every small company that goes on to become the next giant in its industry, there are many more that never get off the ground and eventually fail. Still others manage to tread water or grow slowly but never reach their full potential. By contrast, if you wait until companies are already big, then you don't have to worry about that risk nearly as much.
The benefits of small caps
But beyond posting superior long-term returns, small-cap stocks come with advantages that large caps lack. They include the following:
- Ground-floor opportunity. Small-caps take unproven business models and test them under real-world conditions. When they work, the rewards can be huge. For instance, if you compare Zipcar (Nasdaq: ZIP ) with conventional rental-car companies, it falls well short on financial results -- but the potential growth has investors excited about Zipcar's opportunity to eventually displace those companies and not only take over leadership of car rentals but also eat into car sales as well.
- Undiscovered potential. Look at a typical large-cap stock, and you'll find dozens of analysts covering it. But many stocks have almost no analyst coverage, leaving the field open to lucrative discoveries. For instance, Cheniere Energy (AMEX: LNG ) has only three brokers with price targets on the stock, no formal recommendations, and only two analysts posting earnings estimates. Yet the company has huge potential from its planned liquefied natural gas export terminal in the Sabine Pass area of the Gulf Coast, an opportunity that could turn the ailing natural-gas market into a gold mine.
- Management on your side. By the time a company gets big, institutional investors usually take huge positions in the shares, leaving little if anything for corporate managers. But many strong small caps have huge insider positions. A couple examples: Offshore driller Vantage Drilling (AMEX: VTG ) has 40% insider ownership, and with a combination of drillships and jackup rigs, it's in a hot sector of the market right now. Similarly, Buckle (NYSE: BKE ) stands out from youth-focused retailers not just for its emphasis on service but also because of chairman Dan Hirschfeld's 35% stake in the company.
With all those advantages on your side, it may seem riskier not to own small caps.
Keep your balance
Of course, that doesn't mean you should put all your money into small caps. They tend to be more volatile than larger stocks, and especially as you get closer to retirement, that kind of volatility is a gamble you can't afford to take with your entire nest egg.
But you shouldn't ignore small caps entirely, either. The small-cap tracking iShares Russell 2000 ETF (NYSE: IWM ) may be the most popular choice for exposure, but you'll find better advice in the new issue of Rule Your Retirement. There, Brokamp goes through how to balance your portfolio between large and small stocks, and he also brings in Motley Fool Duke Street advisor Rich Greifner with some tips on how to pick ideal small-cap stocks for your portfolio. With specific stock recommendations, it's an issue you won't want to miss.
Fortunately, you don't have to be a current subscriber to see the latest issue. Just sign up here for a 30-day free trial and get full access to everything else the service has to offer.
No matter how scary the market is, don't let yourself be afraid of small-cap stocks. Adding some to your portfolio could be the best move you ever make.
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