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Does Smaller Mean Better?

Stocks with small market capitalizations—generally, those with a market value of less than $1 billion—had a much better start to 2015 than their large-cap counterparts. The Russell 2000® Index, a proxy for small-cap stocks, returned 4.4% during the first quarter, while the large-cap Dow Jones Industrial Average™ fell 0.3%. By mid-May, the Dow had narrowed the gap, returning 3.63% compared with the Russell Index’s 4.84%, but the difference was still noteworthy.

Much of the disparity has to do with small-caps’ heavier reliance on the domestic economy. Improving economic conditions have been a boon for smaller companies in terms of demand. Growing sales, combined with favorable borrowing conditions, have made it easier for small companies to secure the financing they need to expand.

Then there’s the strong U.S. dollar. A rising dollar hurts the earnings of companies that do a lot of business in overseas markets with weaker currencies. This generally affects large companies more than small ones.

However, the factors that have recently buoyed small-cap stocks also tend to make such stocks more volatile, says Brad Sorensen, Director of Market and Sector Analysis at the Schwab Center for Financial Research. For example, their relative lack of overseas exposure may give small-caps an advantage over large-caps when the U.S. economy is growing, but that advantage becomes a liability when domestic growth slows. Small companies may not be able to rely on overseas sales to make up for weakness at home.

And because they generally lack the financial resources of large companies, small companies are more sensitive to tightening credit conditions, which could be a problem in a rising interest rate environment.

Still, it makes sense for most investors to include small-caps in their stock portfolio, Brad says. After all, because small-caps tend to perform differently than large-cap stocks, they could provide diversification benefits. But investors should proceed cautiously.

“Spread your small-cap investments among multiple stocks, because investing in individual small-cap stocks is just adding another layer of risk,” Brad says.

Exchange-traded funds (ETFs) and mutual funds that focus on small-cap stocks are a straightforward way to diversify your exposure to this group at a relatively low cost.

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Keeping an Eye on the Downside

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

Past performance is no guarantee of future results.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Indexes are unmanaged, do not incur management fees, cost or expenses, and cannot be invested in directly.

The Russell 2000® Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.

The Dow Jones Industrial Average™, also referred to as The Dow®, is a price-weighted measure of 30 U.S. blue-chip companies. The Dow® covers all industries with the exception of transportation and utilities, which are covered by the Dow Jones Transportation Average™ and Dow Jones Utility Average™.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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