Brett Arends’s ROI: Do you need small caps in your 401(k)? Check out this one chart first


If you threw money into a large-company U.S. stock fund during the crash last year, you were smart.

But if you threw money into a small company stock fund, you were smarter.

Since March 2020, the typical small-cap U.S. stock index fund has beaten its large-cap rival by a thumping 40 percentage points, or around 120% to 80%.

That ain’t hay, as the song goes.

What’s going on? And, more important to those of us investing for our retirement: Is it likely to continue? Should we be investing more of our 401(k) or IRA into small-company stocks?

Let all forecasts be stamped with the wise advice of Casey Stengel: Never make predictions, “especially about the future.”

Nonetheless there are reasons to be wary. While small-cap stocks may beat large-company stocks ahead, there is, critically, no particular reason to expect it.

Why not? Take a look at the picture above. It tells a simple story. Using two main indexes, it shows how small-company stocks have performed on average compared with large-company stocks over the past five years.

The recent boom in small-caps can largely be explained through one simple phenomenon: They’ve been catching up.

Small-caps lagged behind large-cap stocks for several years. During 2019 and early 2020 the gap became enormous. So the rally that took place from March 2020 through March 2021 simply brought them back into line.

And that makes reasonable sense. If small-company stocks got cheaper and cheaper in relation to their bigger counterparts, you’d expect investors to snap them up. Sooner or later, a dollar’s profit is a dollar’s profit.

Some experts argue that small-company stocks as a group produce higher returns over time, though with more ‘risk’ — also known variously as ‘volatility,’ ‘stress’ or ‘moments of abject terror,’ depending on where you sit.

The theory that small-caps ‘produce’ higher returns with higher ‘risk’ is the reason many portfolio managers include small company stock funds in retirement portfolios.

But it’s more contentious among experts than most of us in the cheap seats may realize. A few years ago, researchers argued that only the highest quality small companies had produced serious returns. The class overall: Not so much. But recently other researchers have thrown a bucket of cold water even on that. There is no way for ordinary investors to profit from any small cap advantages, they argued.

Of course there is one way of making a good profit from small-cap stocks. That’s to buy them in a buyer’s market, when most investors are panicking and willing to sell at almost any price. Like… er… early last year.

Today the big institutional investors have reversed course. Instead of shunning small-company stocks, since late fall they’ve been positively giddy about them. So it has been a seller’s market. Whether that means the easy money has already been made is another matter. But it’s notable that in the past month you’ve been better off in large-company stocks, as measured by the S&P 500
Coincidence? We’ll have to see.

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