Why doing asset allocation between large and small caps is better than not doing so
First and foremost, there is a large discrepancy in performances when measured over more than 5 years period, between small and large caps throughout the decades. There are times when large caps stocks gained as much as 30% while small caps lost 2% or doubled in value. As a result, there have been greater returns than simply buy and hold ETFs that tracked the broad market when ordinary investors switch from small caps to large caps and vice versa at suitable times. The bad thing is neither your commission based financial adviser or mutual fund managers are going to decide for you when to hold either small or large caps stocks. The consequence of which is that you are leaving cash on the table if you did not switch and shift between small and large caps at the right times.
Why it is that market capitalization of companies affects their performance in various economic climates?
While it is a fact that both small and large caps represent a wide range of industries, with so called different performances in different economic and financial conditions. The following four factors do affect the relative performance of both small and large caps stocks, as can be seen historically. As a result, it follows that the same effect by the same causation will persist in future.
1. Rate of growth in corporate profits
Small caps have a much greater sensitivity to changes in main factors affecting profitability, one of which is labour costs, a slower rate of growth in labour cost translates into much greater profitability of small and medium sized businesses than is for the large ones.
2. Broad economic conditions and growth
During times of strong economic growth, small caps and their stocks are benefiting more than large caps. In other words, they are able to expand more rapidly than large companies. In the reverse sense, during recession, small businesses faced a higher chance of failure and/or their earnings shrink faster.
3. General credit conditions
Businesses seldom don’t need credit from banks and financial institutions to operate. Even large, cash rich companies like Microsoft still got make a bank loan, for reasons of leverage while small and medium businesses are no choices have to borrow money. When times are good, banks are more likely to lend to small companies without too high an interest rate or premium, relative to a large and well known company with strong balance sheet. This can be seem before the subprime mortgage crisis, whereby any Tom, Dick and Harry can loan 100% to finance the purchase of a house, which ultimately causes the subprime mortgage crisis. During periods of financial crisis, prolonged recession and great depression, banks and financial institutions are very reluctant to make loans to small companies, especially just after getting burned, like after the economic crisis during the year 2008. Large companies during hard times are relatively easier to get loans as they are generally perceived to be more stable.
4. Local, regional and international political stability
Theoretically speaking, at least according to this feller, Pradhuman, in his book called Small Caps Dynamics, large caps are good defensive stocks during periods of local, regional and international instability. Common sense will tell you that when the Earth is stable, the general public will feel safe investing in riskier assets such as small caps as they are also potentially able to generate higher returns. However, what is supposed to be true theoretically may not be true sometimes, due to unknown reasons. For instance, after the 911 incident, small caps unexpectedly perform better than large caps until end of the year 2006.
The four conditions result in differences in performances of small and large caps such that periods of time that flavours either of them can last a few years so that you can recognise the trend and profit from it. As you shall see from historical data, there is really a large disparity between returns from large and small caps for any given year. Fortunately, there is a simple asset allocation model that any person of average intelligence can used to increase overall returns from wise and timely shift between large and small caps stocks, no need to have first class honours.
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