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Small Caps Are Riskier Than Large Caps

09/15/11 08:50:06 AM
by Mike Carr, CMT

The current decline in stocks has hit smaller stocks more than larger ones.

Security:   IWM
Position:   Buy

Risk and return are invariably related and greater returns come with greater risk. Numerous studies have demonstrated that small-cap stocks outperform large-cap stocks in the long term. These same studies also show that risk, measured by standard deviation in most academic studies, is great for small caps. In the language of a trader, small-cap stocks will deliver more bang for the buck in both bull and bear markets.

Figure 1 shows IWC, an exchange traded fund (ETF) that tracks the Russell Microcap Index, which is the smallest of the small caps. This index is still more than 20% below its high and it dropped more relative to indexes of larger stocks.

FIGURE 1: IWC, DAILY. IWC fell sharply but is near a breakout point after potentially forming a base with a triple bottom.
Graphic provided by: Trade Navigator.
Figure 1 also includes the relative performance of OEF, an ETF that tracks the large-cap Standard & Poor's 100, and IWM, an ETF tracking the Russell 2000, along with IWC. OEF is the strongest since the decline, because it declined the least.

Smaller stocks generally have wider spreads and less liquidity, which increases trading costs. An interesting point in that chart is that IWC and IWM deliver similar returns. Given that, the added cost of trading microcaps may not be worth it.

FIGURE 2: IWM, DAILY. IWM has a more visible rising trendline in its bottoming pattern than IWC.
Graphic provided by: Trade Navigator.
Given the stronger pattern, IWM (Figure 2) may offer the greatest potential return of these three ETFs if the market continues higher.

Mike Carr, CMT

Mike Carr, CMT, is a member of the Market Technicians Association, and editor of the MTA's newsletter, Technically Speaking. He is also the author of "Smarter Investing in Any Economy: The Definitive Guide to Relative Strength Investing," and "Conquering the Divide: How to Use Economic Indicators to Catch Stock Market Trends."

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Date: 09/15/11Rank: 5Comment: What I find interesting Mike is that the small caps are not leading this rally yet which is somewhat unusual. Small caps tend to lead in real rallies... don t they?

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