It's an old saw on Wall Street: Over the long haul, small-company stocks far outperform big-cap stocks. But how much better? A recent study by pension consultant Wilshire Associates found that the smallest 500 stocks by market capitalization (out of a total of 2,500) returned a nifty 18.6% annually from 1975 to 1991. By contrast, the 500 largest-cap stocks returned 12.5% a year. So $10,000 invested in small caps was worth $220,000 17 years later, after compounding, vs. $83,000 for large caps.
There's a catch, though. Using the Wilshire data, money manager Aronson + Fogler found that those small-cap returns are earned only by buying and holding rather than by trading in and out. If an investor bought and sold the small-cap portfolio once a year, the $220,000 turns into $79,400. But a large-cap portfolio holds up much better, shrinking to only $75,700 from $83,000.
Why? Trading costs are a lot higher for small caps, says Theodore R. Aronson. First, they're much less liquid, and the spread between what investors pay to buy them and what they get for selling is wide. But for big caps, the spread is very narrow, so it costs less to trade them. Second, small caps generally sell for a lot less than big caps. So commissions, which are usually calculated on a per-share basis regardless of stock price, are a larger percentage of the total outlay in small-cap trades. Says Aronson: "Ignoring transaction costs can be hazardous to your financial health."