You Need Small Caps to Balance Your Portfolio

I ran across an interesting study conducted by New York University professor, Aswath Damodaran. Dr. Damodaran examined U.S. markets from 1927 until 2001 – a long-enough window to allow for fairly substantial and reliable (and unbiased) data.

The study revealed that small caps “earn higher returns than larger firms of equivalent risk.” How much higher? “The smallest companies outperformed the largest ones with a 20% annual return versus a 12% return on large-caps on a value weighted [neutral] basis.” The difference in performance between small and large caps is even greater on an unweighted basis so you can see where this is going.

The Motley Fool expanded on the NYU study by compiling two charts that I found quite interesting – a five-year chart of several large-caps and a five-year chart of some well-known small- and micro-caps. Check out the figures.

Okay, the numbers speak for themselves – smaller companies outperform large-caps over a long term (1927 – 2001) and a shorter-term (five years).

So do you need an MBA from Wharton to figure out the driving forces behind this discrepancy in percentage returns? No way. It’s simple.

Small-caps have more room to run, more room to expand and grow. ExxonMobil isn’t going to double in price, even with oil near record highs as of the day of this writing. However, I’ll bet you dollars to donuts that there will be several dozen small- and micro-caps that more than double in share price by the end of the ’08 trading year. In fact, there are a few in our Confident Traders’ Portfolio.

Small Caps Aren’t Any More “Dangerous” Than Big Caps…

…and if you do your homework, follow both technical and fundamental analytics and take your own, natural bias out of the equation (small caps bad; large caps good), you’ll see improved returns over both the short- and long-term.

Small caps and micros add balance to any portfolio, regardless of your investment style. The key is to find those companies with sky-high upside and very manageable and understandable downside risk. How?

You’re in the right place to learn. More to come on adding small caps to your current basket of assets.

Hey, looking forward to hearing from you. Let’s talk in a couple of weeks.