The Big Picture: Maria Vassalou on the Small-Cap Effect
Smaller companies tend to grow faster than larger ones over time. The reasoning is that it’s easier for a company doing $1 million in business to double compared to a company doing $1 billion in annual revenue.
Yet even though investors know that there’s this outperformance, it hasn’t gone away. That reason may be due to several factors, such as the fact that small cap companies tend to be riskier, and that they don’t pay an income.
The data shows that the higher risk in small caps stems largely from the higher risk of default. In that event, an investor could lose their entire stake in an investment.
It’s also clear that when the economy is growing, smaller-cap growth plays will perform well. In a flat or down market, value companies, no matter their size, tend to be the stronger performers.
With a significant amount of today’s capital moving toward passive investing in larger stocks, there may be more opportunities for investors in small-cap stocks.
Even a modest allocation of 10 percent to smaller companies could lead to excess returns for a portfolio that’s largely geared towards generating market returns.
Small cap stocks may provide a worthwhile solution to investors looking to beat the market.