Small caps risky, but pay
Wall Street has been predicting a decline in small-cap stocks for the better part of two years, but their cycle of outperformance continues to surprise investors, particularly after the Russell 2000 index reached a new high last week.
The era of small-cap supremacy started in 1998, endured the tech meltdown and has now stretched into a seventh year. For much of this long run, money has rushed into the category, leaving limited choices among mutual funds as dozens of portfolios shuttered to new investors in the face of rising asset levels.
Because cycles like this have historically lasted for five to seven years, some financial advisers have suggested investors collect their profits and head for the doors. Others say strong fundamentals, relatively low interest rates and easy access to debt are still working in the favor of small companies, and the most bullish note that some small-cap cycles have lasted as long as 10 years.
Trying to figure out what’s next for small caps sounds complicated, and it is. For small investors, the best strategy is to figure out what portion of your fund portfolio you’re comfortable dedicating to this volatile but rewarding asset class, and sticking with it, regardless of what the market is doing.
“Whether small caps will start to underperform or not is hard to call. We know that at some point they will, but whether it’s next year or three years from now, we can’t say,” said Vivienne Hsu, portfolio manager of the Schwab Small-Cap Equity Investor fund (SWSIX).
Though it’s easy to get distracted by the market’s short-term moves, the least painful way to manage your risk is to maintain your allocation and try not to let greed get in the way, Hsu said. If the Russell’s recent surge to a new high of 671.74 gives you the urge to pile more money into your small-cap stake, recognize that you’re chasing performance. If small caps post a precipitous decline and you feel a tickle of panic and yearn to sell, understand that you’re thinking about timing the market, and that chances are you won’t do it well.
In a diversified portfolio, most financial planners agree small caps should play a side role, accounting for no more than 20 percent of total stock holdings even for the most aggressive investors. People who are nearing retirement or anyone with serious aversions to risk probably would be better off with 5 percent or less.
Once you decide what range is right for you, either on your own or with the help of an adviser, keep an eye on your stake. If it inches up – as it would have over the last five years – take it back down to where you know it should be, and relish the opportunity to profit from your winnings. This sort of thoughtful rebalancing is the key to long-term investing success.
If you’re just starting out as an investor, are unhappy with your small-cap fund or just missed the small-cap express, you’ll have to shop carefully, said Laura Pavlenko Lutton, an analyst at fundtracker Morningstar Inc.
Small-cap managers have faced an unusual challenge over the last several years: They’ve had too much money to invest. The most common and often the most responsible solution for a manager who has more money than good choices is to close the fund to new investors.
“It’s a challenge. We would all hope the manager of a small-cap fund would be quick to say, ‘My fund is getting too big, I’m having to make compromises, let’s close it down,”’ Lutton said. “But you the investor really have to keep track of this. You can’t always rely on the fund company to do it.”