Small-cap stocks were the winners last year, which is not a big surprise, as small companies tend to perform better when the economy’s recovering from a recession. This is a fact. So far this year, the small-cap Russell 2000 is lagging early on with a 3.83% gain as of February 9, versus 5.67% and 5.47% for the DOW and NASDAQ, respectively. The numbers may not seem like a lot over a year, but compound it over a longer period and you’ll see the difference it would make to your investment portfolio and retirement savings.
I view the holding of large-cap stocks as an integral part of your portfolio. But, as I’ve indicated, in order to give your portfolio some added returns, you should add small-cap and mid-cap stocks. These stocks add to the risk component of your portfolio, but you are compensated by a higher overall expected return from your investments.
Basic modern portfolio theory tells us that you can increase the expected return of a portfolio by simply adding more risk.
It may sound complicated, but it’s quite simple. Think of it this way. When you buy a stock like General Electric Company (NYSE/GE), it’s considered a “widower’s stock,” in that it can be held for the long term without having to monitor it actively. Of course, this used to be the case, but it simply no longer applies; however, for argument’s sake, let’s categorize GE as a safe play.
GE is what we term a “blue-chip” stock—generally a large-cap company that has a history of steady revenues and earnings and pays a dividend. The company growth tends to be stable and holds little surprise. The expected return from the stock tends to be a mix of dividends (income) and a small growth component. Buyers who buy GE tend to buy the stock for its steadier performance over time, which has been proven over a long period of time.
A standard and simple measure of stock risk versus the market is called beta—a quantitative measure of systematic or market risk that cannot be diversified away and is generally in relation to the S&P 500 or another market/benchmark.
A beta of less than 1.0 implies that a stock has less risk than the market and hence less expected return, whereas a beta of greater than 1.0 implies a higher comparative risk versus the market, meaning possibly higher expected returns
On the small-cap side, take a look at semiconductor company Kulicke and Soffa Industries, Inc. (NASDAQ/KLIC). The stock has a beta of 2.92 versus GE’s beta of 1.75.
This means that KLIC incorporates greater risk than GE and both have higher risk than the S&P 500. The two stocks will tend to move in a positive correlation to the market.
For instance, should the S&P 500 move up, KLIC would in theory move up by 2.92X the move of the index. Should the S&P 500 move down, KLIC would move lower by 2.92X the amount the index moves down.
But a note of warning: buying only higher beta stocks does not necessarily translate into higher returns and it also results in greater volatility.
To increase the overall risk of your holdings, you need to increase the expected return. The most important fact to understand is that you can increase the risk-reward profile of your portfolio by adding small-cap stocks and/or sectors that have higher growth potential.