Should You Consider Small Cap Stocks in the Current Environment?

Small-cap stocks tend to underperform large-cap stocks during a down market as investors sell riskier assets. After all, on an absolute basis, they have significantly higher volatility than large-cap stocks, making them more dangerous to hold during a downturn. As a result, investors would have been wise to shift away from them earlier this year.

 

Small-cap stocks fall further than large-cap stocks in a down market. Source: Royce Funds

That said, global small-cap stocks experience stronger recoveries than large-cap stocks one year after market troughs. And the magnitude of these recoveries tends to offset the sharper declines during down markets. Those lucky enough to buy small-cap stocks near the market trough could benefit from these more considerable recoveries.

Moreover, global small-cap stocks had fewer negative or flat return periods than global large-caps over a rolling five-year period – and no negative returns over 10-year holding periods. So, on the whole, they tend to offer a superior risk-adjusted return than large-cap stocks – particularly when buying after a substantial market decline.

Warren Buffett once suggested that investors buy when there’s blood in the streets. In other words, he prefers to buy assets during an economic downturn when they’re cheaper rather than paying a premium for them in a bull market. And, of course, there’s more than just his spectacular returns to suggest that it’s good advice to follow.

The Russell 2000’s three-year and five-year monthly rolling averages, since inception in 1978, have been 10.8% and 10.5%, respectively. By comparison, the three-year and five-year annualized returns leading up to September 30, 2022, have been just 4.3% and 3.6%, respectively. These data suggest that the index is performing well-below average.

 

100% of the Time, Positive 5-Year Returns Have Followed 5-Year Low Return Markets – Source: Royce Funds

Interestingly, a Royce Funds analysis found that the Russell 2000 tends to significantly outperform after a period of underperformance. As seen above, the index averaged a 13.8% five-year annual return following a five-year period with annualized returns of 0% to 5%. As a result, investors could see a strong rebound from current levels over the long term.

 

Data as of November 14, 2022

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Small-cap stocks have a robust track record of outperforming large-cap stocks on a risk-adjusted basis. While they’ve suffered during the recent market rout, investors may want to consider adding exposure ahead of a potential recovery, particularly given their historical outperformance of large-cap stocks over the ensuing five-year period.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.