U.S. Small-Capitalization Stocks

In stark contrast to the efficient nature of the large- and mid-cap stock markets, the small-cap sector is intensely inefficient. There are thousands of small companies in scores of different industries, scattered all across America and frequently located in smaller, out-of-the-way communities. Investment banking firms cannot make much money on these firms, and hence investment analysts don't cover them. The only way to learn anything useful about such companies is to engage in very hard work: traveling to their locations and talking directly to the management teams, the suppliers to the companies, the customers of the companies, and the competitors of the companies. This isn't what most people think of as fun, and consequently managers who are willing to do it end up in the possession of information about small companies' prospects that is of considerable value, because it is not widely known. Indeed, history shows that, over time, smaller capitalization stocks significantly outperform larger capitalization stocks.

But before we leap to the conclusion that families should load up on small-cap stocks, let's look at the dark side of this picture. The first negative is the high price volatility historically associated with owning small-cap stocks. As we know from reading Chapter 4, investment assets that exhibit high price volatility must produce much higher returns than low volatility assets to achieve the same terminal wealth. Hence, the higher ...

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