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.

In different words, the majority of investors are wise to choose an appropriate allocation of small-cap stock mutual funds and stick to the allocation for the long term. And on a periodic basis, such as once per calendar quarter or once per year, rebalance the portfolio.

However, for active investors, there are smart ways to adjust exposure to small-cap stock funds to potentially enhance long-term performance.

The best economic environment for investing in small-cap stocks

The conventional wisdom with regard to timing small-cap stock investing is that U.S. small-cap stocks have historically outperformed large-cap stocks during rising rate environments.

Periods of rising interest rates are usually during the beginning of an economic recovery or, in different words, the time when it appears 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 the market has been down for a long time, or when it appears there is 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 because their collective fate is not 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 of fewer committees, fewer layers of management and other potential obstructions that exist in the typical bureaucratic organization of large companies. Therefore, 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), as opposed to borrowing money (by issuing bonds) like larger companies. Therefore, higher interest rates have less negative impact on the ability of small companies to grow because they do not rely heavily on loans (bonds) to expand operations and fund projects.

A brief history and caution on small-cap stock timing

In the last two economic recoveries, in the calendar years immediately following recession (2003 and 2009), results were mixed, to say the least. In 2003, 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%, compared to 35.62% and 28.69% for mid-cap and large-cap, respectively. However, this was not the case in the recovery beginning in 2009, where small-caps (27.17%) lost to mid-cap stocks (37.38%) and barely edged out large-cap stocks (26.46%).

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

The lesson here is that conventional wisdom is an oxymoron: Wisdom is knowing that conventions consist of general rules of thumb or averages that do not always apply. Therefore, conventions and wisdom do not always work together. For example, whenever you read an article about buying small-cap stock funds, you are wise to consider the source of the information, which is usually a broker or fund company selling small-cap mutual funds!

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

Disclaimer: 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.