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Surprising New Research: Large Caps Top Small Caps

Many investors seek higher returns by placing extra weight on small-cap stocks at the expense of large-cap stocks. The practice dates to the late 1980s and early 1990s, when a pair of academic studies asserted that the stocks of smaller companies deliver outsized gains that compensate for those companies’ inherent volatility.

But now, two analysts have taken a fresh look at the data and have reached the opposite conclusion. A study by Gary A. Miller and Scott A. MacKillop of Frontier Asset Management demonstrates that large-cap stocks have actually outperformed small caps on a risk-adjusted basis since 1926. The study has important implications affecting how your portfolio is managed.

Market capitalization (or “cap”) is a way to measure the size of a company by multiplying its share price by the number of shares outstanding. Companies that exceed $5 billion by this measure are known as large caps while companies that total $250 million to $1 billion are called small caps, with those in the middle referred to as mid-caps.

MacKillop and Miller acknowledge that small-cap stocks outperform large-cap stocks in terms of absolute long-term returns. Where they diverge from past views is in how much small caps’ extra risk undercuts their performance. While previous studies have asserted that small-cap returns are high enough to compensate investors for the additional risk, the Frontier study suggests that’s not the case. Taking small caps’ added risk into account over the long haul, MacKillop and Miller conclude, means that investors who overemphasize those stocks don’t come out ahead.

The new work differs from the older studies in two main ways. Whereas the earlier researchers chose the stocks to represent large caps and small caps, MacKillop and Miller used existing major indexes as their database. More importantly, they looked at annualized returns rather than average monthly returns. Using monthly returns gives a distorted view of the actual impact of volatility on portfolio performance, MacKillop and Miller say. Consider a $100,000 portfolio that falls 10% one month and then gains 10% the next month. Considered in terms of average monthly returns, the gain and loss cancel each other out, suggesting the portfolio would still be worth $100,000. But in fact, it’s clear that after those two months, it has lost $1,000—because, after falling to $90,000, a 10% gain would take the portfolio’s value back up to only $99,000.

The Frontier study shows there is no particular reason to give extra weight to small caps in your portfolio, because while they may gain more than large caps, that edge is likely to be undercut by small caps’ higher volatility. It may be wiser to weight small caps at their relative value compared with other equities.

We can help you take these new ideas into account by adjusting your portfolio accordingly.

Adopting a truer market weighting offers several advantages, starting with the fact that your investment returns may follow a smoother, less volatile course. That makes it easier for you to sleep at night and less likely you will feel pressure to sell stocks during down periods. Those investors who got out of equities during the 2008 downturn missed out on the powerful rally that followed.

Moreover, it’s important to take your investing timetable into account. While small caps offer higher absolute returns over the long term, a lot depends on when you need to start withdrawing income from your investments. There are many periods during which small caps’ performance has fallen far short of that of the overall market, and beginning withdrawals at such a time would cut into your future returns.

That’s not to say, however, that you should never give extra weight to small-cap stocks, or to any other asset class. There may be times when such a move would make sense. But you shouldn’t do it without understanding the risks it entails.

At bottom, the new study is another confirmation of the importance of effective diversification. The lesson is not to go with large caps only or to give them extra weight, but rather to invest in a broadly diversified mix of investments that fits your timetable, investment goals, and risk tolerance. Overemphasizing small-cap stocks in search of higher returns is not necessarily a strategy that fits with sound diversification principles.


This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice
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