When it comes to grabbing attention among investors, bigger is better. With many of the largest companies in the world, the 30 components of the Dow Jones Industrials (^DJI 1.13%) capture more than their fair share of press coverage. But if you'd rather earn the strongest returns than have a portfolio with stock names you can show off at cocktail parties, then you should take a look further down the size scale, because stocks in those markets aren't just advancing -- they're hitting new all-time highs.
Watching the little stocks grow
Yesterday's big 300-plus-point move higher for the Dow was historic, as the largest Dow gain on the first day of trading after New Year's Day. But with the Dow still more than 750 points below its all-time high from 2007, the large-cap market measure has a long way to go to get itself back to setting records.
By contrast, a couple of lesser-known markets have reached new milestones:
- The Russell 2000 (RUSSELLINDICES: ^RUT) jumped 2.8% yesterday, adding to gains of nearly 15% in 2012. At 14% above its 2007 close, the Russell's new record high shows just how much more progress small-cap stocks have made than their larger peers, and those return figures don't even include dividends, which have become increasingly common among smaller stocks.
- Mid-cap stocks as represented by the S&P Midcap 400 have also set new record highs. Gains of 16% in 2012 and 22% since the end of 2007 show even greater outperformance from the middle of the market capitalization spectrum.
None of this should come as any big surprise to long-term market followers, who understand that the historical returns of smaller stocks have routinely outperformed those of their larger brethren. Let's take a look at some of the reasons why.
Growth potential
One thing that small-cap stocks tend to have more of than large caps is the potential for fast growth. Once a company gets to megacap status, there's only so much further it can go before it starts to run into massive size problems, when economies of scale start to reverse and maintaining the huge bureaucracies necessary to support a huge company becomes a drag on overall performance. By contrast, small companies with room to maneuver can more easily plot paths to success, and more important, make small course corrections along the way that take advantage of new opportunities.
Merger and acquisition potential
The best exit strategy for small-cap investors is for their stocks to grow so big that their companies turn into large-cap stocks. But for quicker returns, the prospect of getting bought out by a large-cap competitor at a premium to their then-prevailing share price is also attractive. Yesterday's deal from Avis Budget (CAR 9.30%) to buy Zipcar (ZIP +0.00%) is just the latest example, as Zipcar shares jumped nearly 50% on the news. In general, buyouts help to add to returns for small-cap indexes overall.
Higher volatility
Small-cap stocks tend to move more violently both up and down than larger stocks. That can be uncomfortable during market declines, especially given that small caps tend to have less trading liquidity and therefore can see particularly harsh short-term moves when selling pressure gets fierce. But when markets go up on days like yesterday, the gains from small caps are often even more impressive, and since markets go up more often than they fall, the volatility tends to contribute to higher returns overall.
Do you have enough small-cap exposure?
With small and mid caps at record highs, now may sound like a dumb time to buy. But every diversified portfolio should have at least some exposure beyond large-cap stocks, and the younger you are and the more aggressive you're willing to be with your investments, the more you should allocate to the smaller end of the spectrum.
Not all small-cap stocks graduate to become market leaders, rewarding their longtime shareholders with multibagger returns. But enough do to make investing in small caps a worthwhile experience. Whether you choose individual stocks or ETFs, take a closer look at how to get small-cap exposure into your portfolio today.
