There are some good reasons all stock investors should have small-cap exposure in their portfolios. For example, small caps inherently have more growth potential than their large-cap counterparts -- after all, most of the stocks currently in the large cap S&P 500 index started out as small caps.
In addition, small-cap stocks are likely to disproportionately benefit from falling interest rates, which is widely expected to happen over the next couple of years. Small caps tend to be more debt-reliant than larger companies, so this could lower borrowing costs, and as risk-free investment returns fall (like Treasury yields), we could see money come off the sidelines and into more speculative companies.
However, choosing small-cap stocks to invest in can be an intimidating task. That's why investing in an index fund like the Vanguard Russell 2000 ETF (VTWO 1.65%), which tracks the Russell 2000 small-cap benchmark index, could be a smart idea.
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A historically cheap time to buy
There is a massive valuation gap between small caps and large caps. At the start of 2025, small caps were trading at their lowest price-to-book valuations relative to large caps since the late 1990s. And since that time, the gap has widened even further.
As of this writing, the average stock in the Russell 2000 trades for 1.8 times book value. Meanwhile, the average S&P 500 component has a price-to-book multiple of 5.0. To be fair, large caps (led by the megacap tech companies) have grown their earnings more rapidly in recent years, but not by enough to justify such a massive gap.
In full disclosure, I've been accumulating shares of the Vanguard Russell 2000 ETF in my portfolio in recent years. In a nutshell, if we get the much-anticipated falling rate environment, it could create an inflection point that leads to small-cap outperformance.
