Reddit Question
Small caps are often described as a higher-risk, higher-return alternative to large-cap stocks.
The usual argument is straightforward: investors take on more risk in exchange for higher expected returns.
But how did that trade-off actually show up in historical outcomes?
Did small caps primarily improve the best outcomes?
Did they improve typical outcomes?
Or did they improve poor outcomes as well?
To explore that question, I compared four portfolios:
All returns are inflation-adjusted and expressed as real annualized returns.
Over shorter investment horizons, small caps behaved much as many investors would expect.
The strongest historical outcomes improved substantially as small-cap exposure increased.
At the 95th percentile:
However, downside outcomes became worse.
At the 5th percentile:
Looking at the middle 90% of outcomes tells a similar story.
The range widened from -11.7% to 24.9% for the S&P 500 to -19.3% to 46.2% for Small Caps.
Over three years, investors appeared to receive higher upside in exchange for greater uncertainty.
The picture changed noticeably over longer periods.
Median outcomes improved as small-cap exposure increased:
The lower end of the distribution improved as well.
At the 5th percentile:
At the 25th percentile:
By ten years, small caps were no longer improving only the strongest outcomes. They were improving a large portion of the historical distribution.
The pattern became even more striking.
Median outcomes remained higher:
The strongest outcomes improved substantially.
At the 95th percentile:
Perhaps most surprisingly, poor historical outcomes did not deteriorate.
At the 5th percentile:
At the 25th percentile:
Over thirty years, small caps improved not only favorable outcomes but also typical and less favorable outcomes.
The trade-off looked very different from what appeared over three-year periods.
One interpretation is that small caps increased uncertainty over shorter horizons while improving outcomes across most of the historical distribution over longer horizons.
Historical data can help illuminate trade-offs, but it cannot determine which outcome an investor should prefer.
This analysis looked only at allocations between the S&P 500 and U.S. Small Cap stocks. Different conclusions may emerge when introducing bonds, treasury bills, gold or other asset classes.
Some investors may focus primarily on short-term downside risk. Others may care more about long-term outcomes and the range of results they were likely to experience over multiple decades.
Explore the data using your own assumptions in the Portfolio Tool.