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If Big Stocks Let You Down, Think Small

An alternative to going big is to think small.

Investors often underestimate the value of small-cap stocks in their retirement portfolio, says Casey Smith, president of Wiser Wealth Management in Marietta, Ga.

On his firm's website, Smith writes: "In 401(k) investing, there is a major asset class that does not get the respect it deserves. In fact, it is largely ignored both by investors and plan sponsors. This asset class, small-cap stock funds, is a very important element in a 401(k) plan. Throughout the history of the stock market, small-cap stock funds have significantly outperformed their larger counterparts."

"Small caps should rank in every single portfolio," he says. "The question is at what percentage. If you look the standard deviation and the risk of small caps, they are still greater than the large-cap stocks. However, for most people you need to take a little bit of that risk to help you keep up with inflation within the portfolio."

He points out that "small-cap stocks should not be a centerpiece for a portfolio, but certainly a building block ... There is a case for small-cap stocks outperforming larger stocks, but we need to remember that larger stocks tend to be more stable, which is why investors, over the long run, are compensated less."

His firm relies on an index-based approach, typically using the S&P SmallCap 600 and investing in ETFs. In its most aggressive portfolios, up to 16% is earmarked for small caps.

"Small-cap stocks have proven to be a long-term healthy asset class," Smith says. "That's certainly a reason we subscribe to them in every single portfolio."

Smith says that, over the past 15 years -- and in past decades -- small-cap companies significantly outperformed the large-cap S&P 500, despite underperformance during the tech bubble.

The reason: "Smaller companies tend to grow at a faster rate and, over time, larger companies still grow, but much more slowly," Smith says.

"Smaller companies have less economies of scale, less complex capital structures, less debt and lean more on a competitive advantage, which can quickly change," he wrote. "What it all boils down to is that smaller companies are more risky, and the investor is compensated for that risk in the long run. This works just the same way a bank demands a higher interest from a person with a lower credit score or a higher risk of default. The market demands that same kind of compensation."
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