Stocks: Time to bet big on small caps?

If history repeats itself, investors holding small-cap stocks stand to gain the most when the economy finally turns the corner, said Steve Schaefer in Forbes. That’s the conclusion that analysts at Russell Investments came to after studying stock market data from the past four recessions. Across the board, investors who stepped into the market three to six months before the economy officially hit bottom saw better returns than investors who tried to time the recovery. But the biggest bump came to investors who “loaded up on small-cap stocks” while the market was down. Why do small-cap stocks do so well? One theory, says Russell analyst Mary Fjelstad, is that investors assume that small companies can adapt to the changing economy more quickly than their bigger rivals.

Investors often “equate” small-cap companies with start-ups “run by smart entrepreneurs looking to be the next Bill Gates,” said Rob Wherry in SmartMoney. Yet the bear market has sunk many large companies into small-cap territory—that is, they now have less than $2 billion worth of shares outstanding. By such a definition, both General Motors and United Airlines’ parent UAL are now part of the “small-cap” universe, and they’re “not exactly a group of budding Microsofts circa 1986.” In a sense, though, this means there’s even more reason to buy into the category. When big companies ­posing as small-cap stocks do get back on track—or get bought—the market will be quick to take note.

Small-cap stocks do occasionally see “huge gains,” but individual investors should dip into them “sparingly,” said John Waggoner in USA Today. For one thing, bulking up on tiny stocks can add volatility to a portfolio without necessarily improving returns: Small-cap stocks represent only about 9 percent of the entire stock market. “Furthermore, if you buy a dedicated small-company stock fund, it will sell stocks that grow to become mid-cap or large-cap stocks.” That means you’d miss out on some of the stock’s best years. Still bent on buying small? Stick with a mutual fund with assets of about $1 billion or less. Anything larger will need to hold “hundreds” of stocks to stay fully invested.

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