We're getting closer to the finish line in our series of articles concerning asset allocation. So far, we've covered how to analyze your ability, willingness and need to take risk -- and what do when one or more of those factors conflict. Then we moved to the equity portion of your portfolio, starting with a discussion about domestic vs. international stocks. Then we tackled another important allocation choice investors need to make: the value stocks vs. growth stocks decision.
That brings us to the next consideration regarding our equity allocation: how much to invest in small-cap stocks versus large-cap stocks. The decision process here is basically the same as the value-versus-growth choice. The risks in small-cap stocks tend to appear during periods of economic distress, which is when value stocks also tend to perform poorly. Large-cap stocks tend to perform better during these periods because large companies have more diverse sources of capital, are less likely to be cut off from those sources and are less prone to bankruptcy.
Reasons to increase small-cap exposure
Increased expected return with increased risk: Investors should tilt toward small-cap stocks if they need to increase the expected return from their portfolios to meet their goals -- but only if they're willing and able to accept the incremental risk of small-cap stocks.
Stable human capital: Investors not particularly exposed to the risk that the economic cycle might turn against them should consider tilting their portfolios toward small-cap stocks. Doctors, tenured professors and retirees with defined benefits generally fit this description. Advertising company executives, construction workers and most commissioned salespeople are more exposed to this type of cyclical economic risk.
Diversification of sources of risk: Tilting more to small-cap stocks maintains the expected return of the portfolio while lowering the exposure to beta (total stock market) risk. This reduces the potential dispersion of returns. The diversification benefit arises from the low correlation of the size risk factor to both the market risk and value risk factors.
Reasons to decrease small-cap exposure
Less stable human capital: Tilting toward large-cap stocks might be a valid strategy for investors vulnerable to an economic downturn. Investors whose business, employment or income might be negatively affected by a poor economy might want to tilt toward larger, safer stocks.
Lower risk: Tilting toward large-cap stocks reduces the volatility of a portfolio. Risk-averse investors and those with a low marginal utility of wealth may prefer to focus on reducing volatility as opposed to maximizing returns.Application: You're a small-business owner whose company tends to do poorly when the overall economy does poorly. With your inherent exposure to small-cap risk, you might want to tilt toward large-cap stocks.
It's important to remember that no one allocation decision fits all. This series has been a guide, aiming to provide insight into territory that can quickly become overwhelming for both new and seasoned investors. Whether it's domestic vs. international, value vs. growth or small-cap vs. large-cap, investors' asset allocations are specific to their own investment policy statements. It's important to weigh each decision carefully when working toward your financial goals.