Did you know that the S&P 500, an index of 500 of America's most recognized and dominant companies, has returned an average of 10% annually over its lifetime? That's nothing to sneeze at, but why don't Wall Street's biggest and baddest corporations generate higher returns?
While the average market value of an S&P 500 stock is roughly $60 billion, it's hard for companies at the top of their industry to grow enough to continue multiplying in size once they reach these levels. Sure, you may get the occasional mega-cap stock ($200 billion value or higher), but a small handful of stocks ever reach that milestone.
You must find the next big thing if you're chasing even larger investment returns. Consider looking at small-cap stocks with values between $300 million and $2 billion. Here is why they can juice up your portfolio returns and how to tell if they're right for you.
Fishing for big returns with small-cap stocks
Most companies in the S&P 500, and large-cap stocks in general, are already at the top of their mountain. They're typically entrenched as industry leaders, generate lots of profits, and repurchase shares or pay dividends. You may have heard these types of stocks referred to as blue chips. On the other hand, small caps are usually young companies that are just hitting their stride. They have rapidly growing sales and may not even be profitable yet.
For investors, the math of significant returns generally favors smaller stocks. Think about it -- is it easier for a mature company with a $100 billion market cap to grow to $200 billion or a rapidly growing small company worth $500 million to grow to $2 billion? The math starts working against a company when it gets to be that big. Huge numbers typically don't grow that fast, and moving the needle gets that much harder.
But if it were that simple, everyone would pile into small-cap stocks. In reality, there's no free lunch. There are some significant trade-offs that investors need to remember before adding small-cap stocks to their investment strategy.
They aren't for everyone
For starters, small-cap stocks tend to be much more volatile than large-cap stocks. You can see below that the Russell 2000, a leading index for small-cap stocks, typically suffers more significant declines than the S&P 500:
Some small-cap stocks have declined as much as 50% to 90% in the current bear market! Investors can flee to safety when times get tough, and small-cap stocks are generally less proven, less followed by analysts, and often unprofitable. It's easy to underestimate how hard it is to hold small-cap stocks through a down market, so you should be comfortable with the risk and volatility that comes with them.
Additionally, these up-and-coming companies are more vulnerable. Most lack a clear competitive advantage and must have a genuinely excellent product or service and strong management to maintain their rapid growth. They might not be profitable and prone to recessions when accessing funding is harder. Ultimately, more stocks flame out than succeed long enough to become large-caps.
A winning small-cap strategy
You can generate great investment returns with small-cap stocks, but you should consider some guidelines to keep you from taking on too much risk:
1. Put in the work.
Remember that most small-cap stocks lack the continuous analyst coverage that blue chip stocks get. A company's strengths and weaknesses might not be apparent, so you must be willing to roll up your sleeves and prepare to learn the company inside and out. If you're uncomfortable with individual stocks, you can invest in small-cap index funds like the iShares Russell 2000 Growth ETF.
2. Diversify.
Even if you study a company more than anyone, you're not going to nail all your ideas. Peter Lynch once said, "In this business, if you're good, you're right six times out of 10. You're never going to be right nine times out of 10." So don't invest like you're going to get them all right; spread your investments out, and let your winners make your bottom line.
3. Move slowly.
Small-cap stocks can be very volatile, so don't buy your intended position size all at once. A dollar-cost averaging strategy can help you here. If you're buying slowly over time, you're more likely to have a solid cost basis. Small-caps typically have more long-term upside, so don't feel you need to guess which price is the bottom. It's unnecessarily risky and usually backfires.
