If you are simply interested in earning equity returns without taking too much risk, investing in a quality basket of large-cap stocks or a low-cost ETF tracking large-cap indices is always a better choice.
There is a popular misconception that to earn higher return one has to take higher risks. And it sounds convincing as well. If there is no reward for taking higher risk, why should anyone take the higher risk? While this positive risk-return relationship holds true across the asset classes, it fails miserably within the asset class.
In layman terms, you can expect higher return by investing in equity rather than bonds, but you should not expect higher returns by investing in the portfolio of high-risk stocks. On the contrary, you may end up earning the higher return by systematically investing in the portfolio of low-risk stocks. I wrote an article titled “Benefits of Low Volatility Investing” on March 7, 2018, explaining why a portfolio comprising low volatility stocks systematically outperform a portfolio comprising of high volatility stocks.
Lure of finding next multi-bagger
I am taking a different approach here to explain the same phenomenon. People invest in small cap stocks despite knowing that small-cap stocks are more volatile and risky than their large-cap counterparts in general. They are willing to take higher risk thinking that by taking the higher risk they will earn higher returns. The lure of finding the next multi-bagger stock and getting rich soon are the key reasons behind such choice.
The easiest way to test whether small-cap stocks earn higher returns is to compare the performance of BSE Sensex and BSE Small-cap index; proxy for large-cap and small-cap portfolios respectively.
The graphics present the performances of BSE Sensex and BSE small-cap index. While it is clear that the risk measured by annualised standard deviation is almost 50% higher for the small-cap index than that of Sensex for three-year, five-year as well as ten-year periods, there is no consistent pattern visible in returns.
Return for Sensex is higher for the one-year, three-year and ten-year period, whereas small-cap index has the superior return for the five-year period. Now, I know that many of you would cry foul saying that I have chosen the time to pen his article when large-cap stocks have done far better than small-cap in the year 2018. BSE Sensex has delivered 7.44% return whereas BSE small-cap index has delivered -24.24% return from in first nine months of 2018. And if I choose a different period the picture will look very different.
But that is not true. Let us take 10-year period of December 2007 to December 2017, and the story remains the same. Sensex has gone up by 1.68 times from levels of 20,287 to 34,057, whereas BSE small-cap index has gone up by just 1.44 times from levels of 13,349 to 19,230. It is evident that even for a reasonably long holding period of 10 years, there is no reward for accepting additional risk. Yes, you will have periods in which small-cap stocks would do better than large-cap and there will be some periods where large-cap stocks will do better than small-cap stocks.
Similarly, you will find investors who have made fortunes in large-cap stocks and you will also find investors who have made fortunes in small-cap stocks. Since risk associated with small-cap stocks is much higher than large-cap stocks, you will find extreme performance in small-cap stocks both on the way up as well as down.
While those who have lost money are less likely to make noise, what we normally hear is the trumpet beating of a few investors who have earned good returns in the given period and that makes us feel that “today’s small-cap are tomorrow’s large-cap” or for that matter, you can find your next multi-bagger by investing in small-cap stocks only. But, looking at the performances of the indices presented here, it is evident that there is no reward for taking the additional risk by investing in small-cap stocks.
So if you don’t want to brag about your skills of identifying next multi-bagger stocks and are simply interested in earning equity returns without taking too much risk, investing in a quality basket of large-cap stocks or a low-cost ETF tracking large-cap indices is always a better choice.
By- Mayank Joshipura. The writer is professor & chairperson (Finance), School of Business Management, NMIMS, Mumbai