Stock Performance and Size

Investors often categorize stocks by there market capitalization. We tend to place stocks into 3 distinct groups: small cap, medium cap, and large cap. When analyzing the various groups it is interesting to note that they do not always correlate and some groups have higher returns than others. Knowing how the various groups react can be an aid in developing your portfolio.

The matrix below displays the returns of large cap, and small cap stocks from 1972 – 2007. When studying the return matrix the first thing that should jump out at you is that the asset classes do not post the same returns. There are times when they both win, they both lose, and when one wins and the other loses. Sometimes the assets classes perform very similar while at other times they couldn’t be farther apart. In other words the asset classes do not correlate perfectly. What you should gain from the matrix is that if you combine both asset classes into a portfolio you will reduce volatility and perhaps risk.

The actual CAGR of large cap stocks from 1972-2007 was 10.94% with a standard deviation of 16.97. During the same time period small cap stocks posted a CAGR of 12.88% with a standard deviation of 21.48. In other words small cap stocks outperformed by almost 2% a year but did so with more risk. The question now become is this statistically significant or a random event. The next matrix shows rolling 10 year returns for small cap and large cap asset classes. Notice that there are times when both outperform but in general they perform very similar.

No one really knows if small cap will continue to outperform in the future. Each side can make a demanding argument and deserves to be listened to. No matter what you decide one thing is true: the two asset classes do not always correlate. This means that adding some small cap stocks to a large cap portfolio is a smart idea. Doing such will reduce volatility and perhaps increase returns which is something we can all agree is a good thing.