How to make money with small-cap stocks

Here’s one of Wall Street’s most poorly-kept secrets: Investors can make good money with the stocks of smaller companies whose names aren’t necessarily household words.

Ever heard of Alkermes PLC ALKS, -4.25% Cubist Pharmaceuticals (acquired by Merck MRK, -1.97%   in January for for $8.4 billion), or Packaging Corp. of AmericaPKG, -1.58% ? I didn’t think so. Neither had I, until I looked at a list of the largest holdings in Vanguard’s Small Cap Index Fund NAESX, -1.30% which represents the asset class known as U.S. small-cap.

I would never own those companies individually, but I’m perfectly comfortable holding them as part of a fund portfolio with thousands of stocks.

(The Vanguard fund’s top holdings also include some more familiar names: Alaska Air Group ALK, -1.41% Rite Aid RAD, -0.39%  and Goodyear Tire & RubberGT, -1.24% to name just three.)

Like value stocks, small-cap stocks are an essential part of a well-diversified equity portfolio. Let’s look at some of the data behind that assertion.

From 1928 through 2014, U.S. small-cap stocks turned in a compound annual return of 12.2% (compared with 9.8% for the Standard & Poor’s 500 Index SPX, -1.42% ).

At 12.2%, an investment of $100 would have grown to $2.2 million over those 87 years (compared with slightly less than $350,000 for the S&P 500).

However, on the way to that fine long-term performance, small-cap stocks gave investors a bumpier ride. Although the average one-year return for this asset class was 16%, there was one year (1933) when small-cap stocks more than doubled (up 110%) and another when they lost 48% (1937).

Of the individual years, 59 produced gains (averaging 31.2%) and 28 produced losses (averaging 16%). Statistically those are mighty good odds — at least if you are willing to lose nearly a third of your money in a 12-month period.

But it would be a rare investor indeed who could set money aside and let it grow for 87 years.

A more realistic period for many investors (perhaps for most investors, if you include retirement) is 40 years. The 1928-2014 data includes 48 such periods.

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