Why do small-cap stocks outperform large-cap stocks?
If you have a greater risk tolerance and longer time horizons, small-cap stocks tend to outperform
The trade-off here is that small-cap companies have more room to grow and can offer investors higher return but with higher risk. From 1926 through 2020, small-cap stocks, on average, outperformed large-cap stocks by 1.6 percent, says Robert R. Johnson, Ph.
In finance terms, efficient markets should still allow for a greater absolute return to higher volatility assets, as a compensation for the volatility. This could explain a persistent higher return for small-caps when compared to large-caps over the long run.
Smaller companies are more sensitive to interest rates than larger companies. Higher interest rates adversely impact smaller companies because they need more money to pay debt-service coverage. When rates are lowered, debt-servicing expenses will decline, benefiting small-cap earnings and stock prices.
Small-caps stocks are more volatile and have less liquidity. Large-cap offers a steady and consistent return, and they have less volatility.
If you have a greater risk tolerance and longer time horizons, small-cap stocks tend to outperform big-caps over time because they are able to grow more rapidly than larger companies. If you prefer stable appreciation and dividend income, big-caps may be more suitable.
A Slowing Economy Could Keep Small Caps Down
A slowing economy is “not particularly favorable for small caps,” Clissold says, as they tend to outperform at the beginning of a bull market or economic expansion.
According to Aswath Damodaran, historically, small-cap stocks have outperformed large-cap stocks during periods of high inflation, such as the 1970s.
Small cap and large cap companies can be defined as growth or value companies: growth companies are expected to grow their earnings at above average rates, while value companies are undervalued in price based on fundamentals.
History shows that U.S. small-cap companies tend to outperform their larger counterparts when inflation and interest rates rise.
Does small-cap value really outperform?
Small, but mighty
Not only have small-cap stocks historically outperformed their larger peers, but they've done so strongly, by an annual average of more than 300 basis points (bps), and consistently, more than 69% of the time (Figure 1).
Analysts forecast that 2024 earnings for small-cap companies will grow faster than large-cap earnings in most regions.
If you cannot tolerate seeing negative returns on your investments at specific periods, you should stay away from small-cap funds. If you cannot see such sharp ups and downs, it is better to stay away from small-cap funds. Explore investing in Large Cap Funds instead.
Small-cap stocks tend to offer greater returns over the long-term, but they come with greater risk compared to large-cap companies. The greatest downside to small-cap stocks is the volatility, which is greater than large-caps.
Over the past 11 recessions, small caps have beaten their larger cousins by over 16% during the 12 months after a recession started. Consider the periods before and after the dot-com crash. The S&P 500 outpaced the Russell 2000 by eight percentage points a year from 1995 to 2000.
Market cap: $1.879 Trillion
As of March 2024 Alphabet (Google) has a market cap of $1.879 Trillion. This makes Alphabet (Google) the world's 5th most valuable company by market cap according to our data.
Given that advisors are fond of saying that small cap stocks are much riskier than the stock of larger companies, it usually surprises investors to find out that, over long periods, small cap funds outperform their large cap counterparts. When you think about it though, it does make sense.
In an analysis of foreign and U.S. investments from December 1998 through June 2023, researchers at index provider MSCI found that small-cap stocks outperformed large firms over 15-year periods about 9 in 10 times.
Individual small-cap stocks offer higher growth potential, and small-cap value index funds outperform the S&P 500 in the long run. Small caps also experience higher volatility, and individual small companies are more likely to go bankrupt than large firms.
- Indian Energy Exchange Ltd.
- Central Depository Services (India) Ltd.
- Aptus Value Housing Finance India Limited.
- Five-Star Business Finance Ltd.
- ICICI Securities Ltd.
- Easy Trip Planners Ltd.
- Eris Lifesciences Ltd.
- CE Info Systems Ltd.
Will small-cap stocks recover?
We expect earnings to drive the next leg higher for small caps. According to FTSE Russell, analysts anticipate that expected earnings growth among companies in the Russell 2000 will rebound by 28.2% in 2024, after an expected decline of 11.2% in 2023. The timing depends somewhat on the ultimate path of the US economy.
We found that small-cap firms have historically outperformed larger ones, especially after recessions and over longer holding periods.
Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies. Diversification does not ensure a profit or protect against a loss in a declining market.
Small caps refer to companies with a market capitalization ranging from $300 million to $2 billion. The stocks of small caps are prone to wide market fluctuations; hence, these are highly risky investments.
| Ticker | Company | Performance (1 Year) |
|---|---|---|
| ROOT | Root Inc | 1220.96% |
| SWVL | Swvl Holdings Corp | 1045.64% |
| CVNA | Carvana Co. | 836.92% |
| ZJYL | Jin Medical International Ltd | 775.82% |
