3 Reasons Why You Should Not Invest in Small-Cap Funds (2024)

FAQs

3 Reasons Why You Should Not Invest in Small-Cap Funds? ›

-Small-cap is known for its volatility or sharp price fluctuations leading to greater uncertainty and risk for investors. Moreover, they also have liquidity concerns, limited resources and stability, and higher rates of failure.

Small-cap stocks are a riskier investment than large-cap stocks. The companies usually have less access to investment capital and are more sensitive to market changes. This makes them a riskier investment.

Risk. Since the stocks of small caps are prone to market fluctuations, they tend to be affected more during the times when the market is hit – such as during recession – and take time to recover from them. Such market behavior makes the investment in small caps higher risk.

Recession risk — Smaller companies have historically underperformed their larger peers during recessions and bear markets. Consider a few 21st century market downturns. During the market pullback associated with the Dot-com bubble,¹ small caps² modestly underperformed large caps,³ turning in -44% compared to -43%.

Small-cap stocks are among the most volatile equity investments, although they can reward investors with the potential for higher growth rates than their larger competitors. Over the longer term, small-cap index funds have delivered superior returns to their large-cap brethren.

The Risk/Return Tradeoff of Small Cap Value

Small-cap stocks, due to their size and maturity in some cases, tend to be riskier than mid- and large-cap stocks. The risk in small caps shows up in two ways. First, small caps tend to have more price fluctuations and share price volatility vs. mid-to-large caps.

Since Aug. 1, 2014, through Aug. 1, 2024, the Russell 2000 index of small stocks has returned 8.91% annually compared with returns of 15% on the large-cap S&P 500. So far this year, small-caps continue to be outshined by their larger brethren.

Small cap performance has been a hot topic lately, with many pundits declaring the small cap premium on life support or dead altogether. To wit, over the last ten years the Russell 2000® Index has cumulatively underperformed the S&P 500® Index by approximately 103% and the Nasdaq 100 Index by an astonishing 332%.

Small-cap stocks may be positioned for a run of outperformance after several years of trailing large-cap averages. If you're interested in adding small-cap stocks to your portfolio, you have a couple of options to choose from.

Advantages of Small-Caps

Despite the additional risk of small-cap stocks, there are good arguments for investing in them. One advantage is that it is easier for small companies to generate proportionately large growth rates. Sales of $500,000 can be doubled a lot more easily than sales of $5 million.

Will small caps do well in 2024? ›

Our 2024 Long-Term Capital Market Assumptions estimate that U.S. SMID-cap equity returns will be robust over a 10-to-15-year investment horizon, even rivalling that of U.S. large caps (albeit with more risk).

Large-cap funds are less risky than small and mid-cap funds. Small and mid-cap funds have higher growth potential than large-cap funds. Large-cap funds are good for conservative investors. Mid and small-cap funds are suitable for medium-risk takers to aggressive investors.

Mid-cap funds offer a balance, providing growth potential with moderate risk. Small-cap funds hold the allure of potentially high returns, but come with the most significant risk. Ultimately, the best allocation depends on your risk tolerance, investment goals, and investment timeframe.

Market experts are anticipating a potential slowdown in the mid and small-cap segments due to their high valuations, which may have reached unsustainable levels.