How to Compare Small Caps vs. Large Caps for Your Portfolio
The addition of both small- and large-cap stocks can increase the amount of diversification in a portfolio and lower the amount of volatility.
Small-cap stocks can outperform when the U.S. economy is strong, but large-cap stocks tend to produce less volatility during tumultuous periods.
Whether an investor should add both types of stocks to a portfolio depends on many factors, such as the retirement age and current market conditions.
"Investors should consider a diversified portfolio across market caps, sectors and regions that is aligned to their risk tolerance and time horizon," says Rick Swope, a vice president of investor education for E-Trade Financial, a New York-based brokerage company.
[See: 25 of the Decade's Biggest Events on Wall Street.]
Here's what you need to know about both small-cap stocks and large-cap stocks:
-- Small caps are younger companies.
-- Large caps tend to be less volatile.
-- International exposure is higher in large cap-stocks.
-- Small caps generate higher annual returns.
Small Caps Are Younger Companies
Small-cap companies are less impacted by a strong or weak U.S. dollar because their earnings are derived domestically. These companies are relatively young companies or newer ones that tend to focus their operations on a specific sector and have a market cap between $300 million and $2 billion.
With their smaller levels of revenue, small caps can help buffer international risks in an investor's portfolio, Swope says.
"When the U.S. economy is relatively strong or during a rising rate environment, small caps can outperform," he says.
Since small-cap companies concentrate in one industry, they have experienced negative profit growth because they typically cannot "withstand the economic and business cycle turbulence that larger companies can tolerate," says Jodie Gunzberg, chief investment strategist at New York-based Graystone Consulting, a Morgan Stanley business.
Small caps tend to be more leveraged with less operational efficiency and less pricing power. Another critical factor is understanding the balance of the impacts from the trade tensions versus the dollar strength.
"The balance of influence varies by sector, largely depending on how much revenue is generated domestically versus overseas," she says.
Large Caps Tend to Be Less Volatile
Many large-cap stocks are considered "blue chips" and have often been a part of portfolios because these companies have tended to generate higher returns over longer periods.
Large-cap stocks are well-established and financially stable companies with a reputation for long-term growth and dividend payments. These stocks have the potential for stability and growth and produce less volatile returns.
Investors have favored blue chips or the stocks in the Dow Jones Industrial Average as a way to maintain the principal for a nest egg.
A large driver of the profit margins of large caps are interest rates, as well as the attractiveness of income-generating alternatives, such as Treasury bonds, says Sam Stovall, chief investments strategist at CFRA, a New York-based investment research company.
Large caps represent mature companies who seek to create shareholder value not only through incremental growth, but also through the return of investments through dividends and share buybacks.
"Investors may expect high returns with large-cap stocks as an ongoing concern, but this is not always the case given the maturity of the businesses represented in this space," says Viraj Desai, senior manager of portfolio construction at TD Ameritrade, a New York-based brokerage company. "Keep in mind that it's generally harder for a $100 billion company to double in size than it is for a $1 billion company to do the same."
[9 Large-Cap Dividend Stocks to Own Now.]
Larger businesses could also have more difficulty in adapting to shifting tastes or business climate.
"Given their size, internal procedures can be highly bureaucratic, slowing the ability to adapt to competing innovations and creating potential for having their business models disrupted," he says.
International Exposure Is Higher in Large Cap-Stocks
Large-cap companies have a market capitalization of more than $10 billion and tend to be multinational companies with higher international exposure.
"Large caps and blue chips are not a perfect Venn diagram as today there are many large-cap stocks that continue to exhibit outsized gains and bouts of volatility," Swope says. "Because of their size and tenured track records, there is a lot of information investors can learn about large-cap stocks before they decide to invest in them."
The S&P Dow Jones Indices estimates that about 45% of the revenue for companies in the S&P 500 come from overseas operations, Stovall says. "As a result, the value of the dollar could either help or hurt the companies," depending on whether interest rates are declining or rising, he says.
Large caps can have more globally distributed revenues, Desai says.
"They could be impacted by both positive and negative macroeconomic trends abroad," he says. "Consider the large-cap business that is expanding into higher growth regions like China and India. These businesses over time become more dependent on driving their growth through the economic success and policies of regions outside of the U.S."
Another factor is how various currencies impact these companies.
"If the dollar is strong, this can be a drag on earnings for large-cap companies that have significant sources of revenue abroad," he says.
Small Caps Generate Higher Annual Returns
Small-cap companies tend to carry higher growth prospects, Desai says.
From a practical perspective, it's easier for a company with a $1 billion market cap to double to $2 billion than it is for a firm with a $100 billion market cap to get to $200 billion.
"Investors can take advantage of this growth by investing in small caps, creating prospects to participate in higher returns," he says.
The prospects for outperformance can be high due to the inefficiencies inherent in the small-cap market since they tend to garner less attention by analysts and the media, Desai says.
"As a result, small-cap stock prices can deviate greatly from what their fair value is perceived to be and active investors may take advantage of these dislocations," he says.
While small caps have generated higher annual returns, the volatility in the returns is greater, Stovall says. From 1979 through 2018, the Russell 2000 posted a compound annual growth rate (CAGR) of 9.2%, excluding dividends reinvested compared to the S&P 500's CAGR of 8.5%.
"The standard deviation of monthly total returns was 18% higher for small caps than for large caps," he says.
Since small caps typically have had a shorter life spans than large caps, they tend to have a higher amount of debt. These companies "will be more adversely affected by an increase in borrowing costs," Stovall says.
Which Stocks Are Better For You?
The bottom line is that since small-cap stocks tend to be more volatile, they are often more appropriate for aggressive investors, Desai says.
"Investors with long-term time horizons and a higher tolerance for risk should have the capacity to add more small-cap stocks than their more conservative counterparts," he says. "In both cases, a little bit goes a long way and small-cap stocks should be considered in the context of an investor's total equity exposure."
One option is to choose a market cap-weighted benchmark like the Russell 3000 index, an index comprised of both large- and small-cap stocks, to be a guide in terms of how to size that portion of the portfolio, Desai says.
"This method ensures that the risk that comes from investing in small caps, does not overwhelm the performance of a well-diversified portfolio," he says.
More From US News & World Report
