The Risk-Reward Trade-Off in Small Caps

Michael Batnick shared a great stat on the Russell 2000 small cap index in a recent post on his blog, The Irrelevant Investor:

This is small caps’ 36th peak-to-trough decline of at least 10% since 2000, with an average decline of 17.1%. Of the first thirty-five corrections, every one of them were accompanied by large-caps also falling, until now (an average decline of 12.8%). 

So there have been 36 separate double digit losses in small cap stocks since the year 2000. That means in that time there has been an average of two and a half corrections of at least 10% every year.  I decided to check out the performance over that period to see if it was worth the pain of living through all of those losses.

From the beginning of 2000 through the end of April of this year, the Russell 2000 is up roughly 170% in total or 7.1% per year. That’s less than the historical averages but remember we’ve lived through two periods during this stretch that cut the entire stock market in half.  The S&P 500 is only up 67% in total over the same time frame or around 3.6% a year.

The magnitude of the average decline in small caps was about 33% deeper than the  average losses sustained in large caps, but the performance was more than double by accepting larger periodic losses.

While small cap stocks don’t always outperform (see The Small Cap Value Cycle), this example is a nice illustration of the risk-reward relationship we would expect to see in financial markets over the long-run.

Larger gains usually come from the possibility of larger losses.  It doesn’t always work out this way, but in theory higher risks should lead to higher expected returns.

Small cap stocks could be set-up to underperform going forward after this massive outperformance.  Mean reversion is a powerful force in the markets and nothing outperforms forever.

There are many market commentators that speak of solid past performance in stocks as if it’s the plague because it’s exciting to talk about the possibility of a crash.  While I admit that a crash is always a possibility, even though it’s historically a low probability event, I’d rather take the time appreciate the fact that small caps have helped a lot of investors who embraced a diversified approach during an extremely difficult investing environment.

Read the rest of Michael’s post here:
The Small Cap Divergence (Irrelevant Investor)

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