In springtime, you may think about what your grandmother told you about farming. "If you feed the horses, you feed the sparrows, too," she'd say, with a twinkle in her eye.
Of course, your grandmother grew up in the city and would also say things like: "Fertilize a flower, stab a weed." Nevertheless, it's astonishing how long old sayings persist, even when they're no longer meaningful to the speaker.
Many people keep money in small-company stock funds because they have heard that over time, small-cap stocks fare better than large-cap stocks. Although there's some truth to that, you should add small-caps sparingly.
Small-company stocks have a market capitalization of about $1 billion or less. Market cap is a company's stock price multiplied by its shares outstanding. ExxonMobil, the nation's largest company, has a market cap of $332 billion. Much smaller Western Refining, which refines crude and runs service stations, has a $901 million cap.
Ibbotson and Associates, the Chicago research firm, says small-cap stocks have gained an average 11.4% a year since 1926, while their large-company brethren have gained an average 9.4% a year. So over the long term, small-cap companies do indeed beat large-caps.
The past 30 years haven't worked out quite as neatly, according to a different set of data from Russell Investments. The Russell 2000 index, which measures small-company stocks, has gained 1,479%, including reinvested dividends. The Russell 1000 index, which measures large-company stocks, has soared 1,779%.
So should you invest in small-cap stocks?
In the broadest sense, you probably don't need them. Suppose you'd put 30% of your portfolio in small-cap stocks 30 years ago and 70% in large-cap stocks. You would have gained 1,688% and increased the portfolio's up and down movements slightly. So a mix of small- and large-cap stocks didn't increase performance or reduce volatility.
Furthermore, if you buy a dedicated small-company stock fund, it will sell stocks that grow to become midcap or large-cap stocks. Often, that means missing a company's hottest years.
In addition, small-cap stocks are a small corner of the universe — about 9% of the entire stock market, when measured by market cap. A simpler solution would have been a fund that tracks an index of the entire universe of U.S. stocks, such as the Russell 3000, which has gained 1,689% the past 30 years.
So if you're looking for a general rule of thumb, you could say that small-caps are optional and that your decision to invest in small-company stock funds depends, in part, on your tolerance for risk.
Nevertheless, small-company stocks are noted for occasional huge gains. During a three-month period ended in March 1991, the Russell 2000 leaped 29.7%.
So is there any particular time that's best to invest in small-caps?
A recent study by Russell Investments showed that the best time to invest in small-company stock funds is just before the economy bottoms. Small-cap stocks often get hit harder than large-caps in a bad economy, so prices are low.
"Bull markets and bear markets distort portfolios," says Steve Wood, senior portfolio manager at Russell Investments. "Investors either overpay for risk or safety." Right now, he thinks, people are underpaying for the risk of small-company stocks.
More important, small-company stocks respond to low interest rates more quickly than their large-cap brothers and sisters. As the banking system heals and banks ease loan terms, small companies get the money they need to expand.
Trying to time the bottom of the economy is a fool's errand, Wood says. So your best bet is to rebalance your portfolio or to start adding to your small-company stock position gradually over time.
If you're looking for a small-company stock fund, try to find one with assets of about $1 billion or less. A fund with an enormous asset base will often have hundreds of stocks in the portfolio — in which case, you'd be better off with an index fund. (Index funds are nearly always wise choices anyway.)
Don't add small-cap stocks just because you've heard it's good. But if you buy the notion that small-caps fare best after a recession, this might be the time.
John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. new book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is firstname.lastname@example.org. Twitter: www.twitter.com/johnwaggoner.