Small Caps Generate Big Results

In a previous post, I reviewed the DFA Micro Cap Fund, a great way to invest in small companies, some of whom will go on to have a huge impact on your portfolio returns. The simple fact is that most investors are underexposed to small caps. Many portfolio allocation models have a token exposure to anything other than large company stocks in the US. There is a general perception that small caps are just too risky to have a large allocation.

While it is true that small companies are not as established as blue chips like Walmart, McDonald's, and Intel, they are not as risky as you might think. From 2000-2018 Vanguard's S&P 500 Index returned 5.29% annually with a maximum drawdown of 50.97% during the financial crisis. Vanguard's Small Cap Index returned 8.65% per year during the same period with a maximum drawdown of 53.95%. So yes, the small-cap fund did have a bigger selloff during the crisis, but it wasn't a big difference considering the magnitude of what was occurring.

Of course, you wouldn't want to go all small-caps, because we don't know what is coming in the future. Why not have a market-agnostic view of future returns? We don't know what will perform better, large or small, so it makes sense to have a balanced exposure to both. A 50/50 portfolio of large and small-caps resulted in a return of 7.02% annually with a maximum drawdown of 52.11%.

There will most certainly be periods in which large-caps outperform and stretches when small-caps win. The wise investor recognizes that a long-term policy will incorporate a healthy exposure to both. Knowing your risk limitations is critical before you purchase any investment.