Over the last few days, a great many investors--as well as commentators in the business media--have made the shocking discovery that midcap and smallcap stocks are volatile. I mean, who would ever have imagined that these stocks can actually fall? What an idea, sirji.
I guess this is something that has to be relearned every few years, or sometimes even every few months. In fact, this is one of the oldest and most sacrosanct rules of equity investing and is true across all markets in the world, under all circumstances: Smaller companies' stocks are more volatile than those of larger companies. There may be individual exceptions, but as a trend, this is pretty much inviolable. Investors forget this at their own peril.
The problem, as far as I can see, is that we tend to lose sight of such basics, even though they are actually quite straightforward. Perhaps, there is some element of wishful thinking involved here. When midcaps are zooming, they are doing so well that investors really build a psychological need for them to keep winning. Then, when they inevitably fall, we are surprised and dismayed and disappointed.
Even so, what we always need to understand is quite simple. Here are some things that investors need to appreciate. Smaller companies fall and rise, but some never rise again. Investing in them is risky because the penalty for choosing the wrong one is far higher than that of choosing the wrong large-cap. When the markets rise, practically all large caps rise with them. The exceptions are there, but are few. When the markets fall, all large-caps fall but few fall a whole lot more than the general trend. Midcaps and smallcaps are different. They tend to over-perform and underperform by a larger margin, sometimes a huge margin. When the downward trend reverses, all large-caps tend to follow. However, among smaller companies, there are always some recover poorly or don't recover at all. There is simply much more variation in the returns that they generate.
Why does this happen? There are two kinds of reasons--investing-related ones, as well as fundamental ones. Investing-related reasons are obvious. Smaller companies tend to be much less known and understood by analysts and investors. There are so many more of them, the information flow is poor and a lot more information stays hidden. There is simply less economic incentive for the investing community as a whole to deploy enough resources to do enough research on each such company. Moreover, smaller companies' shares are less liquid than that of large companies. When more than a few investors try to buy or sell the stock, it is likelier that their actions will drive the price, again adding to the variation. Worse, this can easily become a market-wide stampede, as it happens periodically.
The business reasons are different, but of more interest to serious investors. Most smaller companies are not going to stay at the size they are for too long. If they are going to do well, they will become much bigger businesses in a matter of years. This will bring windfall returns to investors. If they do badly, they could decline and disappear as businesses, with the opposite effect on investors' wealth. This is the real reason that investing in smaller companies can be so rewarding, or so punishing.
This becomes amply clear when we examine mutual funds that specialise in investing in small caps. In 2017, these funds were up 55 per cent in one year. Over a longer period like ten years, small-cap funds are up an average of 16.58%, or 4.6 times. Mid-caps are up 15.67%, which is 4.3 times. Large-caps are up 10.87%, which is 2.8 times. Of course, this does not mean that it's straightforward to get such returns--the task of selection can be tougher in small caps.
At the end of the day, smaller companies live at a different point on the risk-return continuum than do larger ones. As investors, we have to choose how much of our investments do we deploy where.
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