Is Small-Cap Stocks Good for Long Term Investing?

HomeWARIs Small-Cap Stocks Good for Long Term Investing?

By Mezhar Alee

August 3, 2023

0

154

Introduction
Defining Small-Cap Stocks
The Allure of Small-Caps
Explosive Growth Potential
Historical Outperformance
Diversification Benefits
Risks of Small-Cap Investing
Higher Volatility
Lower Liquidity
Elevated Business Risk
Lack of Coverage
Small vs. Large Caps: Key Differences
Who Should Invest in Small-Caps Long Term?
Strategies for Investing in Small-Caps
The Bottom Line
FAQs

Introduction

Small-cap stocks are shares of smaller companies that offer explosive growth potential, but also higher volatility. This raises the question — should long-term investors allocate a portion of their portfolios to these higher-risk, higher-return stocks?

This comprehensive guide provides an in-depth analysis on the pros and cons of small-cap investing for building long-term wealth. Read on to learn whether small-cap stocks deserve a strategic role in your lifelong investment approach.

Defining Small-Cap Stocks

First, what exactly are small-cap stocks?

Small-caps are stocks of companies with a total market capitalization (share price multiplied by number of shares outstanding) between $300 million to $2 billion.

Meanwhile, large-cap stocks have a market cap exceeding $10 billion. These larger companies are typically well-established leaders in their industries, such as Apple, Microsoft, Amazon, and other blue-chip stalwarts.

Here are some key features of small-cap firms:

They are in early stages of development with huge runways for growth.
Most are younger, lesser known companies compared to industry titans.
They often operate in specialized niche industries.
Their annual revenue is under $1 billion in most cases.
They have greater risk relative to large-cap companies.

Some prominent examples of small-cap stocks include AMD, Etsy, Five Below, Monster Beverage, Exact Sciences, and Generac Holdings.

While definitions vary, micro-cap stocks are even smaller, with market caps under $300 million. Mid-cap stocks fall between small and large caps, with market caps between $2 billion to $10 billion.

The Allure of Small-Cap Stocks

What makes small-cap companies so enticing for enterprising investors seeking market-beating returns over the long run?

Explosive Growth Potential

The biggest appeal of small-caps is their potential for enormous gains if they evolve into leading firms. Growing from $300 million to over $10 billion in market cap leads to dramatic share price appreciation.

For instance, Monster Beverage stock skyrocketed over 38,000% over the past three decades as the company grew rapidly from a small-cap to a large-cap.

Other prominent examples include NVIDIA and AMD, which gained around 5,700% and 2,500% respectively in just the last decade alone.

Such multibagger return potential can rapidly amplify an investor’s wealth over the long run. Finding just a few small companies that turn into 10x or 100x winners can supercharge overall portfolio returns for decades.

This asymmetric upside potential makes small-caps especially attractive for enterprising investors with long time horizons.

Historical Outperformance

According to investing expert Fidelity:

“Over the past 90 years small company stocks have outperformed large company stocks in terms of total return in the United States. Small caps beat large caps in the U.S. in 63% of the rolling 25-year time periods from 1926 to 2020.”

While past performance never guarantees future results, the data indicates that small-cap stocks have delivered higher total gains compared to large-cap stocks over extended periods historically.

This outperformance makes sense given small companies’ much higher growth trajectories compared to larger, mature firms. Investing in these businesses early allows investors to ride the growth curve.

So for investors with long time horizons, small caps have historically delivered market-beating returns relative to simply buying larger, established companies.

Diversification Benefits

In addition to higher return potential, small-cap stocks also provide portfolio diversification benefits.

As Charles Schwab notes, small caps have tended to be less correlated to the returns of large-cap stocks. Adding small caps to a portfolio that only holds large companies can help manage overall risk exposure.

Morningstar also points out that during recessions, small caps tend to get hammered much less than larger companies. This downside protection can cushion investors’ portfolios during periods of economic contraction.

So the diversification and risk management properties of small-cap stocks further support their role in long-term portfolios.

Risks of Small-Cap Investing

However, investing in small caps also carries notable risks that investors must be aware of:

Higher Volatility

Due to their smaller scale and limited resources, small-cap stocks see much sharper price swings compared to large caps. Their shares can rise and fall dramatically with quarterly earnings reports, analyst ratings changes, macroeconomic conditions, competitor news, product launches, and other events.

Per Charles Schwab:

“Small-cap stocks are about 1.5 times more volatile than large caps. Over the past 15 years, as measured by standard deviation, small caps averaged 23.4% compared to 15.4% for large caps.”

This heightened volatility means small-cap investors should brace for a bumpier ride with more severe ups and downs, especially over shorter timeframes. Their smaller size and financial resources also makes them more vulnerable to industry disruptions and downturns.

Lower Liquidity

Thinly traded small-cap stocks suffer from substantially weaker liquidity versus their larger peers. This makes it more difficult for investors to execute trades at optimal prices when buying or selling.

Wide bid-ask spreads are also more common among small caps, further increasing transaction costs. So lack of liquidity can be a headache for small-cap investors.

Elevated Business Risk

Younger, smaller companies have a meaningfully higher likelihood of bankruptcy or failure compared to larger companies with decades of successful operations. Limited financial resources also makes small caps more vulnerable to competitive threats, industry headwinds, lawsuits, supply chain snags, and other adversities.

Hundreds of small caps go bust each year, underscoring their precarious nature as speculative emerging companies.

Lack of Coverage

Smaller companies tend to fly under the radar, receiving little attention from financial analysts compared to leading large-cap stocks.

As a result, less third-party information and analysis is available to gauge the quality, valuation, and growth prospects of small caps. This makes identifying promising small companies more challenging.

The lack of coverage also means fewer market participants are aware of investment opportunities among attractive small caps early on.

Key Differences: Small Caps vs. Large Caps

Here is a comparison of some key metrics between small-cap and large-cap stocks:

MetricSmall-Cap StocksLarge-Cap StocksMarket Capitalization$300M — $2BOver $10B# of Firms~2,000~500 (S&P 500)Growth OutlookHighModerateVolatilityHighModerateLiquidityLowHighFailure RiskHigherLowerAnalyst CoverageMinimalExtensiveDividendsRareCommonExamplesAMD, Monster, EtsyApple, Microsoft, Amazon

In summary, small-cap stocks offer explosive growth opportunities but at the cost of higher volatility, risk, and uncertainty. Large-cap stocks provide stability and income potential but with slower, steadier returns.

Who Should Invest in Small-Caps for the Long Run?

Given this risk-return profile, do small-cap stocks deserve a strategic role in long-term investment portfolios?

The suitability depends greatly on an investor’s goals, timeline, and risk tolerance. Here are some guidelines:

Aggressive Investors — Significant small-cap exposure is warranted for investors with very long timelines and high risk tolerance. The long runway allows properly sized small-cap positions time to drive market-beating compound returns over decades.
Moderate Investors — A 15–25% allocation to small-caps provides a good risk-return balance. This allows participation in the long-term growth potential while limiting volatility.
Conservative Investors — A smaller 5–15% allocation is prudent for capturing some upside while restricting risk. Conservative investors may prefer small-cap funds over picking individual stocks.
Income Investors — Small caps generally don’t pay dividends, as they reinvest cash flows into growth. Income investors should instead focus on mature, higher dividend large-cap stocks.
Younger Investors — Younger investors with long time horizons until retirement are ideal candidates for small caps. The decades ahead allow small positions time to substantially compound wealth.
Retirees — Small caps are riskier for retirees given short time horizons. However, a tactical 5–10% allocation can boost overall portfolio returns during distribution years.

So small-cap stocks deserve consideration for most long-term investors. Used strategically based on personal risk parameters and timelines, they can enhance overall returns.

Strategies for Investing in Small-Caps

Here are some strategies to invest successfully in small-cap stocks for the long run:

Diversify — Spread your exposure across at least 15–20 small caps to mitigate individual stock risk. Broad-based small-cap index funds instantly provide wide diversification.
Rebalance Over Time — Rebalance holdings periodically to lock in gains on top performers and maintain target small-cap allocation.Trim winners to redirect gains into lagging stocks with more upside potential.
Think Long Term — Tune out short-term noise and volatility. Give your small-cap holdings 3–5+ years to realize their potential through business growth and multiple expansion. Avoid panic selling on temporary dips.
Focus on Quality — Carefully select individual small caps with attributes like strong management teams, clean balance sheets, high insider ownership, leadership in a growing niche, promising products or services, etc. Quality protects against downside risk.
Buy At Reasonable Valuations — Be selective and patient in making purchases. Don’t chase overly inflated small caps. Look for sound stocks trading at discounts relative to their growth outlook.
Dollar Cost Average Over Time — Build positions gradually via recurring investments, rather than making a single lump sum purchase. This smooths out volatility risk. Enroll in automatic 401k or IRA contributions.
Consider Alternatives — Beyond public stocks, explore early-stage investments like private equity deals, angel investing, or venture capital funds for exposure to small private companies with potential to go public or get acquired down the road.But recognize the risks and illiquidity.

The Bottom Line

Small-cap stocks offer the compelling potential for market-beating returns over the long run. Their early stage rapid growth can substantially compound wealth over decades for investors with long time horizons.

However, their volatility also demands prudent position sizing, diversification, quality stock selection, and patience from investors. Used strategically, small caps can play a pivotal role in enhancing portfolio returns over the long haul.

Just align small-cap exposure thoughtfully with your personal risk tolerance, investment objectives, and investing timeline to fully harness their asymmetric return potential while managing the downside risks.

FAQs

Q: What percentage should I allocate to small caps for the long run?

A: 15–25% is a reasonable starting point for investors with long timelines. More conservative investors might limit small-cap exposure to 5–15% instead.

Q: How long should you hold small-cap stocks?

A: At least 3–5 years, but ideally 7–10+ years. Their long-term growth curves require patience. Don’t react to temporary volatility.

Q: Are small-cap index funds a good choice?

A: Yes, small-cap index funds like IWM provide a diversified, low-cost vehicle for participating in the asset class. They provide instant exposure and built-in rebalancing.

Q: Can retirees invest in small-caps too?

A: Generally minimal exposure is recommended for retirees given short time horizons and income needs. But a small tactical 5–10% allocation can boost overall portfolio returns.

Q: Do small-caps pay dividends?

A: Some do, but most small-caps retain earnings for growth instead of distributing dividends. Income investors are better off focusing on mature, high dividend large-cap stocks.