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How Much Small Cap Should Be in Your Portfolio?

It may come as a surprise to those who have placed their nest eggs in an S&P 500 index fund, or an actively managed version thereof, that they are actually making a decision to exclude a significant portion of the equity universe.

Academic theory, particularly William Sharpe’s capital asset prices study, suggests market-capitalization (cap) weighting is an appropriate starting point for the weight of any asset class in the portfolio, including small caps. Market-cap weighting implies that the investor holds each asset and therefore each asset class in his or her portfolio in the same proportion as it is represented in the overall market. Determining market weight is an exercise in and of itself, because you must first settle on a definition of what constitutes a small or large stock. Standard & Poor’s defines the ratio of large to small stocks in the U.S. equity market as about 80%/20%. This means that if your portfolio is an S&P 500 investment, you are missing out on a good 20% of the publicly traded universe in the U.S. equity market.

A variety of considerations might motivate an investor to deviate from a 20% weight to small caps in the U.S. Home equity bias,

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