All equity investments carry a variety of risks. Small-cap companies carry different kinds of risks than those one would likely associate with large-cap companies. They have greater growth potential and tend to offer better returns over the long-term, but they do not have the resources of large-cap companies, making them more vulnerable to negative events and bearish sentiments.
- 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.
- Historically, small-caps have posted higher returns than large-caps, albeit with greater volatility.
- Large-cap companies are typically a safer investment, especially during a downturn in the business cycle, as they are much more likely to weather changes without significant harm.
- Because small-caps are more nimble, small-cap companies can take more chances and take advantage of events and trends.
This vulnerability is reflected in the volatility of small-cap companies, which has historically been higher than that of large-cap companies. They are an especially risky investment during a period of economic contraction, as they are less well-equipped than large-cap companies to cope with sharply decreasing demand.
Higher Returns, Higher Volatility
With high volatility, the returns realized by investors vary significantly from the average return they expect, making actual returns more difficult to predict and making the investment potentially riskier.
For example, from 1997 through 2012, the Russell 2000 (an index of small companies) returned 8.6% on an annualized basis, compared to 4.8% for the S&P 500 (consisting mainly of large companies). Yet in the same period, the Russell 2000 had approximately one-third higher volatility.
In the period from 2003 through 2013, the volatility of small-cap funds as measured by standard deviation was 19.28. For large-cap funds, it was 15.54. Over the same period, small-cap funds yielded an average annual return of 9.12%, and large-cap funds yielded a return of 7.12%.
In short, this means that the return of small-cap funds varied from its average by 19.28 percentage points 68% of the time, and the return of large-cap funds varied from its average by 15.54 percentage points 68% of the time. The higher variability of small-cap funds reflects higher volatility.
Large-Caps Are Safer Investments
Large-cap companies are typically a safer investment, especially during a downturn in the business cycle, as they are much more likely to weather changes without significant harm. This makes them more attractive to investors, attracting a stable stream of capital, which contributes to making their volatility low.
On the other hand, large-cap companies do not have the growth potential of small-cap companies, as their size prevents them from quickly changing direction and capitalizing on new opportunities; the larger resources that cushion them can also be a burden.
Because small-caps are more nimble, small-cap companies can take more chances and take advantage of events and trends. This, in turn, leads to them historically having a better return on investment (ROI) than the big guys.
On the other hand, large-cap stocks also tend to pay dividend yields. Dividends can provide more stability to their stocks. These dividends also lead large-caps to play it safer, choosing to pay dividends versus invest in capital expenditures (CapEx).