Consider Market Caps for Diversification

The extreme market volatility of 2020 has rattled investors’ nerves, but it also can provide an opportunity to diversify at discount prices. One way to diversify the equity portion of your portfolio is to hold stocks of companies of different sizes, which tend to perform differently under different market conditions.

The most convenient and comprehensive way to diversify by size is through mutual funds or exchange-traded funds (ETFs) that track indexes based on market capitalization, calculated by multiplying the number of outstanding shares by the price per share. There is no standard classification system, but these Standard & Poor’s indexes, which are used as benchmarks by many funds, offer a helpful comparison of market-cap levels:1
S&P 500: $8.2 billion or more
S&P MidCap 400: $2.4 billion to $8.2 billion
S&P SmallCap 600: $600 million to $2.4 billion

Average annual returns 1990 to 2019: large caps gained 9.96%, mid caps gained 12.04%, small caps gained 10.87%. 2000 to 2019: large caps gained 6.06%, mid caps gained 9.50%, small caps gained 9.80%. 2010 to 2019: large caps gained 13.56%, mid caps gained 12.72%, and small caps gained 13.35%.

Russell indexes are also commonly used to construct funds based on market capitalization. The Russell 1000 includes large and midsize companies, while the Russell 2000 is the most comprehensive small-cap index.2 Actively managed funds focusing on market capitalization typically include stocks chosen by the fund manager rather than follow an index.

Stability, Growth, and Volatility

Stocks of larger companies, or large caps, are generally considered more stable than the stocks of smaller companies. Large caps may provide solid long-term returns, but they typically have lower growth potential because they have already experienced substantial growth to reach their current size.

Mid caps may have greater growth potential than large caps, and midsize companies might react more nimbly to changes in the business environment. Mid caps are associated with higher risk and volatility than large caps but are considered more stable than small caps.

Small-cap stocks might offer the highest growth potential of the three classifications because they have the furthest to grow and are more likely to react quickly to market opportunities. However, they are typically the most risky and volatile class of stocks.

Diversification is a widely used method to help manage risk; it does not guarantee a profit or protect against investment loss. The investment return and principal value of stocks, mutual funds, and ETFs fluctuate with market conditions. Shares, when sold, may be worth more or less than their original cost.

Mutual funds and ETFs are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.