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How small-cap stocks can help you diversify Some pros and cons Investment strategies Understanding small-cap stock funds

One of the most interesting theories to emerge from stock market research is that which describes the so-called small-firm effect. Its premise is that stocks of smaller companies tend to outperform stocks of larger companies. However, while small-cap stocks have historically earned higher returns than other types of investments, they also carry a higher risk of market fluctuations.* Therefore, they may be appropriate for investors with a long investment time frame who hold a well-diversified portfolio.

Small-Cap Stocks Defined

Cap refers to the market capitalization of the company issuing stock. The company’s total market capitalization includes the value of stock and debt outstanding. Although definitions of what constitutes small cap can differ, a commonly used benchmark for small-cap funds, the S&P SmallCap 600 Index, includes companies with capitalizations less than $1.4 billion.

Many smaller companies serve niche markets with steady consumer demand for their products and services, or emerging industries with the potential for substantial future growth. Such companies may experience above-average earnings growth or have earnings that are less susceptible to changes in the overall economy. On the other hand, the smaller capitalizations of these companies can make it harder for them to sustain a business downturn. Also, they tend to have more bank debt relative to total capital than do larger firms, so profits of some smaller companies may be sensitive to rising interest rates.

Small-Cap Stocks: Some Pros And Cons

Although large-cap stocks were generally the top performers in the late 1990s, historically, small-cap stocks have outperformed the overall market, and have outperformed since 2003.* Over time the difference has been dramatic. For the 50-year period ended December 31, 2012, $1.00 invested in large-cap stocks would have grown to $106; the same investment in small-cap stocks would have grown to $357.** This past performance does not guarantee future results.

Small companies typically do not pay dividends. They also are more thinly traded than stocks of larger companies. These factors tend to make small-cap stocks more volatile than large-company stocks. While the purchase or sale of 10,000 shares would have little effect on the price of a blue chip stock, it could have a major impact on a smaller company with a similar share price.

*For the 10-year period ended December 31, 2012. Source: Standard & Poor’s. Large-cap stocks are represented by Standard & Poor’s Composite Index of 500 stocks, an unmanaged index considered representative of the U.S. large-cap stock market. Small-cap stocks are represented by the S&P SmallCap 600 Index, an unmanaged index. Past performance cannot guarantee future results. Individuals cannot invest directly in any index.

**For the 50-year period ended December 31, 2012. Sources: Center for Research in Securities Prices, University of Chicago 1963-1993; Standard & Poor’s, 1963-2012. Large-cap stocks are represented by Standard & Poor’s Composite Index of 500 stocks, an unmanaged index considered representative of the U.S. large-cap stock market. Small-cap stocks are represented by the Center for Research in Securities Prices 6th-10th Decile of New York Stock Exchange from 1963 to 1993 and the S&P SmallCap 600 Index from 1994 to 2012, unmanaged indexes. Past performance cannot guarantee future results. Individuals cannot invest directly in any index.

Average 12-Month Rates of Return