When Is the Best Time to Invest in Small-Cap Stocks?

Strategies for Mutual Funds That Hold Small-Cap Stocks

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Small-cap stocks and the mutual funds that invest in them can be smart long-term holdings, but knowing the best time to buy small-cap stock funds can help boost long-term returns. Most investors are wise to avoid the purest forms of market timing, but there are some strategic and tactical moves investors can make to adjust small-cap stock fund allocation at certain opportune times.

Some investors choose an appropriate allocation of small-cap stock mutual funds and stick to the allocation for the long term. They rebalance the portfolio on a periodic basis, such as once per calendar quarter or once per year. There are some smart ways for active investors to adjust exposure to small-cap stock funds to potentially enhance long-term performance, however.

The Best Economic Environment for Investing

Conventional wisdom says that U.S. small-cap stocks have historically outperformed large-cap stocks during rising rate environments. Periods of rising interest rates usually occur during the beginning of an economic recovery, or at a time when it appears that the Federal Reserve will no longer decrease interest rates to stimulate the economy.

Another way to look at the best time to buy small-cap stock funds is when it seems that the market has been down for a long period of time. It appears that there's no optimism about the market—a potential low point.

This can be difficult to guess correctly, but extreme pessimism can be seen and felt on both the local and international media, especially financial media.

When and Why Small-Cap Stocks Can Beat Large-Cap Stocks

From an intuitive perspective, small companies can begin to rebound in growing economies faster than larger companies. Their collective fate isn't tied directly to interest rates and other economic factors to help them grow. Like a small boat in the water, small companies can move faster and navigate more precisely than the large companies that move like giant ocean liners.

Decisions about new products and services and how to bring them to market can also be made and implemented faster with small companies because they have fewer committees, fewer layers of management, and fewer potential obstructions of the kind that exist in the typical bureaucratic organization of large companies.

When the economy begins to emerge from recession and starts growing again, small-cap stocks can respond to the positive environment quicker and potentially grow faster than large-cap stocks.

Small companies—and most growth-oriented stocks across all capitalization—typically raise most of their capital from investors by selling shares of stock. Larger companies borrow money by issuing bonds. Higher interest rates have less negative impact on the ability of small companies to grow because they don't rely heavily on bonds to expand operations and fund projects.

A Brief History

Results were mixed, to say the least, in the calendar years immediately following the recessions of 2003 and 2009.

Small-cap stocks (the Russell 2000) led mid-cap stocks (the S&P Midcap 400) and large-cap stocks (the S&P 500) with a return of 47.25 percent in 2003, compared to 35.62 percent and 28.69 percent for mid-cap and large-cap stocks.

This was not the case in the recovery beginning in 2009, however, when small-caps lost to mid-cap stocks 27.17 percent to 37.38 percent, and they barely edged out large-cap stocks at 26.46 percent.

Most recently, small-cap stocks had a gain of 22 percent in 2016 when the Fed starting raising rates after a long period of easing, which trounced the S&P 500's gain of 12 percent.

Use Caution With Small-Cap Stock Timing

The lesson here is that conventional wisdom is an oxymoron: General rules of thumb or averages do not always apply.

For example, you're usually wise to consider the source of the information, which is often a broker or fund company selling small-cap mutual funds, when you read an article about buying small-cap stock funds.

With that said, buying more shares of small-cap stocks during bear markets and just as it appears that the Fed will begin raising rates can often be a good idea for active investors.

The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.