Have you noticed this trend?

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This week, we’ll dive into the division between the big and little guys in the stock market, and provide a short quiz to test your financial acumen.

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Why the little guys can’t catch a break

Have you noticed the trend playing out in the stock market right now? Small cap stocks are not receiving the same love as large cap stocks in the market. Small cap stocks are much smaller companies than the large companies that make up the S&P 500 and Dow Jones Industrial. These small cap stocks have a much smaller total valuation when counting the cumulative value of all their shares versus the big boys. The most popular index that tracks thousands of small cap stocks is the Russell 2000. For the Russell 2000 the average market cap is around $4.4 billion. In contrast, the average market cap of the companies that compose the S&P 500 is much larger, including several companies with a market cap of more than $1 trillion.

When taking a look at the returns of the Russell 2000 versus the S&P 500, one notices a sharp difference in growth over the past year (as of Thursday, June 13).

• Russell 2000 1-year return: ~9.7%

• S&P 500 1-year return: ~25%

Part of reason for the divergence between the two indexes has to do with the popularity of large companies for investors at this moment. These include the silicon valley darlings Meta, Alphabet, Microsoft, and Nvidia which have seen massive growth in the past two years. Investors seem comfortable investing in these companies due to their strong revenues, pricing power, and positive cash flow. However, there is another factor strongly contributing to the runaway success of the S&P 500 versus the Russell 2000.

Higher interest rates are making small caps unpopular compared to large cap stocks. Interest rates first and foremost change borrowing costs for both consumers and businesses. Interest rates are less of an impact for larger companies who can rely on strong cash flows and favorable borrowing terms compared to smaller companies. More specifically, smaller cap companies often have to borrow money to finance their operations to do things like buy equipment, hire more staff, and service their existing debt. Since rates are higher, these small caps have less money to support their operations, therefore it seems a riskier bet to invest in these companies when rates are and will likely remain elevated for the next few years.

The next question you probably have is: when does it make sense to invest in small caps? We can’t provide advice on that topic but we can explain some likely reasons why an investor would invest in small caps now or in the future. The first reason is diversification. There will very likely be a period of time when small caps experience more growth than the large indexes. Once that period comes, having some of your portfolio allocated to small caps will allow you to experience those gains. For a long term investor, timing the market is very low on the priority scale. A long term investor is not overly worried about missing out on the larger gains you would experience now if you were only investing in the S&P 500, because one day these same outsized gains will likely occur for those with money allocated into small caps.

Again, each individual’s investment needs are different. Still, for those who believe in diversification it may make sense to continuously allocate into small caps to realize gains in these companies at a time when large cap stock are struggling or seeing inferior returns.

This week’s quiz

Are you ready? We have two personal finance questions to test your financial acumen.

Question 1

Question 2

Answers

Question 1

Answer: D

For tax year 2024, the limit increased to $23,000. Remember, 401(k) contributions reduce you taxable income in the tax year contributed. Additionally, employers often match a percentage or amount of contributions which is a nice benefit to take advantage of each year.

Question 2

Answer: C

You can take contributions out tax free at any time with a Roth IRA, however in order to take out Roth IRA earnings tax free, you will have to be age 59.5 AND have made your contribution at least 5 tax years prior to your first withdrawal.