U.S. Small Cap stocks are defined as those stocks that are generally among the smallest 10 percent of the market universe.

Small Cap Stocks carry with them higher economic risks and thus have higher costs of capital associated with them. Smaller cap companies often have to pay higher interest rates when they take out a loan from the bank when compared to larger, more well-established firms. Similarly, when they issue common stock they receive lower prices versus larger firms. This means higher expected returns for investors.

The historical returns and volatility of the smallest deciles of market capitalization have been thoroughly studied. As indicated in the table below, small cap stocks have provided returns in excess of those of the overall stock market as measured by the Standard & Poor’s 500 Index (large cap stocks), although investors would have had to accept increased volatility in the process.

*Source: DFA, CRSP 6-10 Index (CRSP data are provided by the Center for Research in Security Prices, University of Chicago

What should make small cap stocks especially attractive, however, is not just their potential return premium; but rather the fact that the returns to small capitalization issues are not strongly correlated with those of large stocks, such as our recommended high-yield Dow shares. In the table below, we present market returns by deciles. Large stocks (decile 1) and small cap stocks (decile 10) provided the greatest “swings” in terms of gains and losses over three-year rolling periods, but most importantly, these swings were not correlated. For example between 2002 and 2004, small caps averaged 29.17% annually, while large caps returned only 1.7%. Conversely, between 1987 and 1989, small caps gained 2.82% while large caps gained 17.06%. The point is, though no one can predict these patterns of relative performance in advance, for a given level of risk they are willing to accept, investors can maximize their potential returns by holding both groups of assets.

Annual Stock Market Returns (NYSE, AMEX, NASDAQ)

Lowest returns are in red, highest are in green

CSRP data provided by the Center for Research in Security Prices, University of Chicago. The S&P data are provided by Standard & Poor’s Index Services Group. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.