Benefits of Diversifying to Help Bridge the Returns Gap
As a result of the global coronavirus pandemic, there has been a disparity of returns among asset classes this year. Different types of investments, including stocks, bonds, and precious metals, always have differing returns. However, the disparity of returns can become especially large during an economic downturn or global crisis. This disparity is known as the returns gap.
The reason for this is that investors move funds into assets they view to be more secure, or they may sell off assets if they’re in need of cash.
Small Cap stocks have trailed Large Cap stocks by 15% YTD and 10% over the past 3 years. Let’s look into what this means and how investors can navigate the current economic situation by building a diversified portfolio.
Small vs. Large Cap
Companies are broken into small, medium, and large market capitalization (cap) categories. These categories are based on the size of the company in terms of valuation. They are also a good indicator of potential risks and returns.
A company’s valuation can be found by multiplying its stock price by the number of shares outstanding. For example, if a company has 200,000 shares trading at $20 each, it has a market capitalization, or market cap, of $4,000,000.
The Russell 2000 is a stock index which tracks 2,000 small cap stocks, whereas the S&P 500 tracks 500 large cap companies. Some investors choose to buy index shares in order to gain exposure to the broader market without the risk of selecting individual companies to invest in.
Although there are no set rules for what defines a small, medium, or large cap company, in general the following divisions are used:
Small cap are companies with a market cap between $300 million and $2 billion. These stocks have a tendency to be volatile and risky as short term investments, but they also have huge upside potential. Many small cap companies are penny stocks, meaning their stock is priced under $5. Investors who buy at these low prices can see large returns as the company grows, but the company also has more potential for failure. Not all small cap companies are new, risky startups though. Some of them are stable and established businesses that can make for solid investments.
Mid cap companies are with a market cap between $2 billion and $10 billion. These are established companies that aren’t huge corporations, but they have the potential for significant growth.
Large cap companies with a market cap of $10 billion or more. This includes global companies with recognizable names. Large cap companies tend to be older and more established, but some newer companies. These companies tend to be more stable investments, but they don’t have a lot of potential for growth. One added benefit of investing in large cap companies is that they are more likely to pay out dividends.
Some analysts put companies with a valuation over $200 billion into an additional ‘mega-cap’ category, but this isn’t a widely used term.
Although small cap stocks tend to be volatile and have a higher level of risk in the short term, they also hold great potential for long term investors. Small companies are more focused on growth than large companies, and it’s easier for them to grow. It’s much easier for a $300 million company to grow 10% than a $10 billion company.
Historically, small caps have kept pace with, and even outperformed, large cap stocks, especially during economic downturns.
For example, from 1990-1993, the Russell 2000 performed 48% better than the S&P 500 during the recession and slow economic recovery period which followed. The Russell 2000 also rose by 114% between the years 1999-2013, through a recession, two wars, and the global financial crisis.
During economic expansions, large cap stocks tend to outperform small cap. This was the case between 1983-1990, 1994-1999, and 2013-2020.
Since the Russell 2000 Index was listed in 1979, it has mostly had a similar performance to the S&P 500 and the Russell 1000.
So far in 2020, small cap stocks haven’t been faring nearly as well as large cap. This is unusual for an economic downturn.
The S&P 500 is down -0.38% this year, while the Russell 2000 small cap index is down 14.09%. Over the past three years, the S&P 500 is up 11.66%, but the Russell 2000 small cap index is only up 1.71%.
One theory for why this is happening is that the Russell 2000 includes far fewer technology, consumer staples, and consumer discretionary stocks. The S&P 500 large cap index comprises more than 25% tech stocks, while the Russell 2000 includes many health care, financial services, and industrial stocks. The recent performance of these sectors could affect the overall performance of each index. However, analysts have looked into this hypothesis and found that the relative weights of sectors in each index have little effect on their current performance.
Between December 2019 and May 5, 2020, small cap stocks underperformed large caps in every sector except utilities. The returns gaps have been significant, with a 12% underperformance in technology and 37% in consumer discretionary stocks.
Other theories have included changes to interest rates and rising market volatility, but neither of these factors has proven to be the cause of the current gap.
As it turns out, the main reason for the current underperformance of small caps seems to be that smaller companies have been harder hit by the lockdown and COVID-19 pandemic than larger companies.
In past economic crises, smaller companies were able to quickly adapt and evolve more quickly and easily than large companies. This allowed them to continue to perform relatively well while larger companies struggled. However, the current crisis is different, since in-person work and commerce has grinded to a halt. That, along with the health scare and sudden spike in unemployment, has hit small cap companies hard.
Diversifying Investments to Bridge the Returns Gap
Past performance isn’t a predictor of the future, as is being proven in the current market. This is why diversification is key when building a strong investment portfolio. Nobody could have predicted the timing of the current global crisis, and the effect it would have on any particular asset class.
A well-diversified portfolio includes both small cap and large cap stocks, as well as mid cap. This helps ensure that during both growth periods and recessions investors gain exposure to market increases while mitigating their risk of losses.
For example, the Russell 1000 large cap index has actually increased by 0.10% so far this year. Investors who hold shares of a fund tracking this index along with shares of a fund tracking the Russell 2000 small cap index have seen less of a loss than those who only hold the Russell 2000 small cap.
It’s also a good idea for investors to think long term when building their portfolio. Attempting to time the market can result in significant losses. Instead, build a diverse portfolio that will generate steady returns over time.
If you’re looking to start building a diversified stock portfolio, there are many great tools available on the market to help you. By opening a SoFi Invest® account, you gain access to up to date market news, in depth educational materials, and a full suite of investing tools right at your fingertips. Using the SoFi app, you can track your favorite stocks and even buy fractions of popular stocks using SoFi Stock Bits. SoFi offers both Active and Automated investing options, so you can hand select each stock you want to add to your portfolio, or set up automated investments in pre-selected groups of stocks.
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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.