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.
Key Takeaways
- 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).
FAQs
Small-cap stocks are riskier and more volatile investments, as they do not have the same financial resources large-caps do and are still developing their businesses.
Is small-cap riskier than large-cap? ›
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.
Are small-cap companies riskier? ›
2. Risk. Since the stocks of small caps are prone to market fluctuations, they tend to be affected more during the times when the market is hit – such as during recession – and take time to recover from them. Such market behavior makes the investment in small caps higher risk.
Which is more risky small-cap or mid-cap? ›
Mid-caps are slightly riskier than large-cap stocks and less risky than small-cap stocks. Small-cap stocks are riskier than the other two. Despite the risk, these stocks have great growth potential. Large-cap funds are usually less volatile unless there is some news.
Why are small-cap companies more volatile? ›
Small caps are also more susceptible to volatility due to their size. It takes less volume to move prices. It is common for the price of a small-cap stock to fluctuate 5% or more in a single trading day. That is something that many investors simply cannot stomach.
Why small-cap companies are risky? ›
Credit risk — The cost of borrowing is higher for smaller companies. Indeed, the cost of equity is higher, too. Lower average valuations for share buyers translate into higher cost for the companies issuing those shares. This is consistent with the underperformance of smaller company shares when times are tough.
Why are small-cap riskier? ›
One is that, when it comes to trading, small-cap stocks have less liquidity. 3 For investors, this means enough shares at the right price may be unavailable when they wish to buy—or it may be difficult to sell shares quickly at favorable prices.
Is it better to invest in large-cap or small-cap? ›
Large-cap companies are typically more stable, with established technologies, substantial cash reserves, and a proven track record. While small caps have the potential to outperform in a declining scenario, the higher risk associated with them should be carefully considered by investors.
Is small-cap risky in long term? ›
Small-cap mutual funds perform well over a long period of time. However, over a short period of time, they tend to be very volatile. So if you plan on withdrawing/redeeming your money from the mutual fund early, you could suffer losses. Sure, you could also make gains, but there is always the risk.
Why do small caps outperform large caps? ›
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.
Small-cap stocks are riskier and more volatile investments, as they do not have the same financial resources large-caps do and are still developing their businesses.
Do mid caps do well in a recession? ›
If, on the other hand, the economy begins to slow down or enter a recession, then mid-cap companies will outperform small-caps. As seen in the figure below, mid and small-caps (represented by the S&P 600) perform well in the early stages of the business cycle as soon as people sense a recovery.
Do small caps really outperform? ›
That is: Small-cap stocks have outperformed in prior interest rate cutting periods — and their exposure to higher interest rates wasn't as bad as feared.
Do small-cap stocks outperform in a recession? ›
Investors pay close attention to the performance of smaller stocks because it offers signals about the health of the U.S. economy. Smaller companies typically outperform coming out of a recession. They rallied briefly in late 2020 after Covid-19 vaccines boosted hopes about an economic recovery.
What are the problems with small-cap stocks? ›
A Risky Proposition
A major risk for low-priced securities is the limited amount of publicly available information. Many of these securities are issued by small or emerging companies, which can make it difficult to find comprehensive information about the company's finances or business model.
Why do people invest in small-cap stocks? ›
Small-cap stocks have a long-term performance advantage over large-cap stocks, and this is often referred to as the small-cap effect. Small-cap stocks are said to be economically sensitive and therefore rally in recoveries and lag heading into recessions.
Is it better to have a large-cap or small-cap during a recession? ›
Investing in small caps during recessions has generated superior investment returns, according to our back-testing of the data to the late 1980s (see Table 1, below).
Are small-cap funds better than large-cap? ›
Small cap funds can offer higher returns than large and mid cap funds, due to great potential for growth. However, they are more volatile due to their nature and company size.
Will small caps outperform large caps? ›
That same principle can be applied to differences in companies' size, small cap versus large cap for example, and on that basis, small cap stocks are due a period of strength. They have underperformed for a while, but over time, they outperform large cap, and that relationship will be restored at some point in time.
