I Wouldn’t Touch Individual Small-Cap Stocks With a 10-Foot Pole Right Now

The common theme in investing is more risk, more reward. Fixed-income investments, like bonds and certificates of deposit (CDs), can provide guaranteed returns, but they’re extremely low. Stocks can provide virtually unlimited return potential, but there’s always a chance you could lose money.

The same risk-reward trade-off applies to different types of stocks, as well. The bigger the company, the more stable it likely is because of the resources that generally come with more size. But that usually reduces the chance for exponential growth.

Small-cap companies have a market capitalization between roughly $300 million and $2 billion. Because of their small size, they have a chance for hypergrowth, providing great returns to their investors along the way. However, with this chance for hypergrowth comes more risk because small-cap stocks are more prone to volatility and may not have as many resources as large-cap companies to weather bad economic storms.

Focus on small-cap index funds

Owning small-cap stocks is a good decision for any investor, but during bear markets, when volatility may be intense, it’s a good idea to avoid investing in individual companies and focus on small-cap index funds that track the U.S. small-cap market as a whole. The Vanguard Russell 2000 ETF (NASDAQ: VTWO) is one example.

The Russell 2000 index is largely considered the primary benchmark for small-cap stocks (similar to the S&P 500 for large-cap stocks). With an investment in the Vanguard Russell 2000 index fund, you’ll be instantly invested in 2,003 small-cap stocks covering all 11 main sectors.

There’s no guarantee that specific small-cap companies will make it through the bear market unscathed, but it’s a safe bet that a broad index like the Russell 2000 will find a way to rebound and produce good returns in the long run. Even though small-cap stocks usually take more of a beating during bear markets, they also tend to reap more of the rewards in early bull markets and when the economy is recovering.

Now’s the time to go discount shopping

Small cap-stocks have high volatility and risk, so you never want the bulk of your portfolio to be in them. However, you do want some exposure to small-cap stocks because of the growth potential. If it’s not too much of your portfolio, you can generally justify the risk. You likely won’t see Amazon-like returns if you’re invested in a broad small-cap index fund like the Russell 2000, but the index has proven to be a good long-term investment, especially if you’re able to grab shares at a “discount.”

From September 2008 to March 2009, during the Great Recession, the Russell 2000 dropped over 46%. From there, it increased over 100% less than two years later. From its February 2020 high to March 2020 low, it dropped close to 40%. It’s since increased over 79% since then, even while being down over 20% year to date (as of July 21, 2022).

Of course, historical performance doesn’t guarantee future performance by any means. However, if you focus on a small-cap index like the Russell 2000, you can be more confident that it will weather the storm and provide long-term returns.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Stefon Walters has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon. The Motley Fool has a disclosure policy.

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