The expectation of outperformance of small caps relative to large caps is often dubbed the “small-cap premium.” A premium can arise for both rational economic reasons as well as behavioral considerations. If small caps are expected to outperform large caps, then some investors can increase their portfolio returns relative to the market by overweighting small caps. Essentially, an investor is well served by allocating his or her financial capital among different types of equities (i.e., diversifying), so that a bad period for one asset class can be offset by a potentially good (or at least less bad) period in another. Uncorrelated assets do not move in perfect concert with each other. One of Harry Markowitz’s seminal findings on investing is that one can increase the return of the portfolio for a given amount of risk (or volatility) by simply adding uncorrelated assets. We submit that it is probably worth most investors’ time to at least consider a position in small caps, if for no other reason than to diversify an existing portfolio of large caps. Home equity bias, inertia and a simple desire to minimize complication in portfolio allocation decisions are likely chief among them. equity market.Ī variety of considerations might motivate an investor to deviate from a 20% weight to small caps in the U.S. This means that if your portfolio is an S&P 500 investment, you are missing out on a good 20% of the publicly traded universe in the U.S.

Standard & Poor’s defines the ratio of large to small stocks in the U.S. Determining market weight is an exercise in and of itself, because you must first settle on a definition of what constitutes a small or large stock.

Market-cap weighting implies that the investor holds each asset and therefore each asset class in his or her portfolio in the same proportion as it is represented in the overall market. It may come as a surprise to those who have placed their nest eggs in an S&P 500 index fund, or an actively managed version thereof, that they are actually making a decision to exclude a significant portion of the equity universe.Īcademic theory, particularly William Sharpe’s capital asset prices study, suggests market-capitalization ( cap) weighting is an appropriate starting point for the weight of any asset class in the portfolio, including small caps.

Top micro cap stocks 2014