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.