The stock market is a continuous cycle of ups and downs. There are generally more ups than downs, but there will always be both at some point. That seems to be the only certainty in a market infamous for its uncertainty.
Although all three major indexes -- the S&P 500, Dow Jones, and Nasdaq Composite -- are up so far in 2023, the past year or so in the stock market has largely been defined by a bear market. Nobody can say for certain when there will be another bull market, but one thing's for certain: It'll happen eventually. And one of the best things investors can do is put themselves in a position to take advantage of it.
One such way is stocking up on a Russell 2000 ETF. Let's see why.
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The role that small-caps can play in your stock portfolio
Small-cap companies have a market capitalization between roughly $300 million and $2 billion. When it comes to investing, there's usually an inverse correlation between size and risk. Large-cap companies (those with a market cap above $10 billion) generally have more resources at their disposal, so they're normally more stable. It's because of their large size, though, that their growth potential is often much less than that of smaller companies.
Small-cap companies are more prone to volatility and more sensitive to economic conditions, but their smaller size leaves them with more potential upside. Where there's a lot of room for a business to grow, there's money to be made for investors who go along for the ride.
The Russell 2000
The Russell 2000 is an index that tracks the smallest 2,000 companies in the Russell 3000. It's considered the benchmark for small-cap stocks, similar to the S&P 500 for large-cap stocks. Since there's more risk involved with investing in small-cap companies, investors can do themselves a favor and minimize some of the risks by investing in a broad Russell 2000 ETF.
Although Russell 2000 ETFs follow the same index, they will have variations, such as the number of stocks held and cost. For example, the Vanguard Russell 2000 ETF (VTWO 1.61%) contains 1,941 companies and has a 0.10% expense ratio, while the iShares Russell 2000 ETF (IWM 1.55%) contains 1,925 companies and has a 0.19% expense ratio. All in all, you can't go wrong with the Vanguard ETF because of its low cost.
The Vanguard 2000 ETF also provides diversification, containing companies from all 11 major sectors. The top five sectors are financials, healthcare, industrials, consumer discretion, and technology, and they account for just under three-quarters of the fund.
The tide will often turn
During bear markets and times of economic uncertainty, investors generally lean on large-cap companies because of their relative stability. That's why small-cap stocks tend to get the short end of the stick during bear markets. However, the opposite also tends to be true. During bull markets, small-cap stocks will often outperform large-cap stocks.
Let's take the bull market that occurred in the early stages of the COVID-19 pandemic. From April 2020 to the end of 2021, the Russell 2000 outperformed the S&P 500. Yet, during last year's bear market, the Russell 2000 saw its value drop noticeably lower than the S&P 500. The same occurred during the Great Recession, with the Russell 2000 dropping over 46% from September 2008 to March 2009 and then doubling in value less than two years later.
You can't guarantee this trend will continue, but now may be the time to take advantage of fallen prices and go "discount" shopping. The Vanguard Russell 2000 ETF is down over 28% from its November 2021 highs, and if you haven't already, now may be the time to start (or begin increasing) your stake.
You shouldn't want a large portion of your stock portfolio in small-cap stocks because of their volatility and risk, but you should give yourself some exposure to benefit from their growth potential. A good rule of thumb would be to have 5% to 15% of your stock portfolio in small-cap stocks, depending on your risk tolerance and closeness to retirement. The closer you are to retirement, the less of your portfolio you should want in small-cap stocks.
