Why Adding Small-Cap Stocks Can Boost Your Overall Gains

Why Adding Small-Cap Stocks Can Boost Your Overall GainsSmall-Cap Stocks Prove Their Value Over Time

For much of my investment career, I have focused predominantly on small-cap stocks as a sound strategy to achieve higher expected returns. These stocks entail higher risk, but they also provide a portfolio with the potential to increase overall gains.

Generally, small-cap stocks have market caps ranging from $300.0 million to $2.0 billion.

This could be a good year for small-cap stocks; the economy is expected to continue to grow by around two percent (or higher).

Add in the new phase-one trade deal between the United States and China that could generate another $200.0 billion in exports over the next two years, and the economic growth could accelerate.

Regardless, small-cap companies tend to be less dependent on the global economy, instead deriving a large portion of their sales domestically.

The Bull Case for Small-Cap Stocks

To track small-cap stock performance, I monitor the direction of the Russell 2000 index.

In the period from 1988 to 2019, the Russell 2000 delivered positive returns in 22 of those 32 years, with an average return of 10.2%. Nine of those years saw returns of more than 20% for the small-cap index.

The high for the Russell 2000 during those years was a return of 45.4% in 2003, while the low was a decline of 34.8% during the Great Recession in 2008.

Over the last 20 years, the Russell 2000 outperformed the S&P 500 in 12 of those years (60% of the time). The Russell 2000 failed to beat the S&P 500 from 2017 to 2019, but it may be set for bigger moves ahead.

Small-cap stocks perform well following recessions, which is why investors should not be very concerned if a recession materializes in 2021 or 2022.

Since the Great Recession, the Russell 2000 generated annual gains in eight of 11 years.

Going back to Black Monday in October 1987, when the stock market crashed, the Russell 2000 subsequently gained 22.4% in 1988.

In fact, there have been three recessions since 1988. In each case, the Russell 2000 subsequently staged a nice multi-year rally.

Worrying About a Recession? Don’t.

The recession that began in July 1990 lasted eight months. The Russell 2000 declined by 21.5% in 1990, prior to spiking 43.7% in 1991.

The index was positive in seven of the 10 years leading up to the next recession (in 2001), averaging an impressive return of 14.7%.

The 2001 recession was short-lived, lasting only eight months, from March to November of that year. The Russell 2000 fell 21.6% in 2002 as the economy began to recover, but surged by a 32-year best of 45.4% in 2003.

The index rose in four of the six years leading up to the Great Recession, averaging 9.7%.

Then we witnessed the Great Recession from December 2007 to June 2009. The Russell 2000 plummeted 34.8% in 2008.

In the aftermath of the Great Recession, the Russell 2000 jumped 25.2% in 2009 and 25.3% in 2010. Then, as mentioned earlier, the index rallied in eight of 11 years after that, averaging gains of 12.8% during that time.

Analyst Take

Small-cap stocks should represent part of a complete investment strategy. As shown above, the historical results support this view.

For those who are concerned about a recession being on the horizon, the evidence shows that small-cap stocks perform well in the years following an economic slowdown.