When it comes to investing in the stock market, one common debate among investors is whether to focus on small caps or large caps. Small cap stocks are generally considered to have higher growth potential, while large cap stocks are seen as more stable and reliable. In this article, we will analyze the performance of small cap and large cap indices over a period of almost 19 years and provide some insights into how investors can approach this conundrum.
To begin with, let’s take a look at the Nifty and small cap index of the BSE (Bombay Stock Exchange). Over the span of almost 19 years, the returns on both these indices have been remarkably similar. This finding is quite counterintuitive as conventional wisdom often suggests that small caps outperform large caps over the long term. However, the evidence presented by the historical data indicates that large caps have actually given similar returns, even without accounting for dividends.
If we dig deeper into the peaks and troughs of these indices, we can observe some interesting patterns. The peaks and troughs tend to occur at the same time for both small caps and large caps. For example, they peaked in December 2007 and experienced a bottom again in January 2009. Similarly, they reached another peak in October 2010 and bottomed out in December 2011. However, there was a deviation in August 2013 when small caps were down while the Nifty was up. This suggests that there can be periods of divergence between the performance of small caps and large caps.
Now let’s examine the performance from peak to peak or trough to trough. During the market fall in 2008, small caps fell by almost 77% while the Nifty fell by nearly 55%.
In the subsequent fall, small caps fell by about 40%, whereas the Nifty fell only about 11% during the same period.
The COVID-19 pandemic-induced market fall saw small caps plummet by approximately 50%, while the Nifty fell by around 17% from the same point.
These numbers demonstrate that small caps tend to experience sharper downturns compared to large caps, despite the impressive recoveries they often witness.
The significant drawdowns in small caps mean that even the substantial recoveries they make are only able to catch up with the returns of large caps. Taking the example of the post-COVID recovery, small caps surged by 362% over a three-year period.
This outstanding performance might lead some to believe that investing solely in small caps would always be the best strategy. However, the overall average returns eventually catch up, and the next major drawdown in small caps can erase this advantage over time.
Given these insights, it is advisable for investors to strike a balance between investing in both small caps and large caps. Additionally, having strategies in place to avoid deep drawdowns in small cap portfolios can help leverage the potential alpha small caps offer in each market cycle. If an investor wishes to minimize volatility, they can lean towards large cap stocks, as these tend to play a crucial role in an investment portfolio. It is worth noting that while small caps may outperform large caps for a certain period, eventually, large caps will either start outperforming or small caps will plateau, resulting in a convergence of their performances.
The historical analysis of long-term charts offers valuable lessons for investors. Despite the potential for alpha in small caps, investors must exercise caution and control the drawdowns in their small cap portfolios to generate positive returns. Implementing strategies that focus on riding winners and quickly cutting losses can be a great approach for those who want to capitalize on small cap stocks. On the other hand, investors seeking a more stable and predictable investment experience may find better opportunities with large cap names.
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