Market capitalization is one of the most basic concepts in investing. It is the dollar amount a company is worth. Market capitalization is calculated by multiplying the number of shares outstanding by the prevailing share price.

The definition of what separates a large-cap stock from a mid-, small- or micro-cap stock is a topic of debate. There is no single universal cutoff. The S&P 500 index, the most widely followed large-cap index, requires companies to have a market capitalization of at least $5.3 billion as of August 2016. On the small-cap side, the S&P SmallCap 600 targets stocks with market capitalizations between $400 million and $1.8 billion. FTSE Russell defines large-cap companies as those whose market capitalizations rank among the 1,000 largest. Small-cap companies are those with the 1,000th to 3,000th biggest market capitalizations.

Dartmouth professor Kenneth French defines large-company stocks as those ranking in the top 30% of market capitalizations of New York Stock Exchange (NYSE) listed companies. Small-company stocks have market capitalizations ranking in the bottom 30%. In between are mid-caps or middle companies. As of January 2017, French calculates large-company stocks as having an average market cap of $38.9 billion and small-company stocks as having an average market capitalization of $347 million.

The line between small-cap and micro-cap isn’t clear either. The AAII Model Shadow Stock Portfolio sets the maximum market capitalization a company can have to be considered for purchase as being equivalent to a company ranking in the bottom 10th percentile in terms of market capitalization of all NYSE stocks.

A strict adherence to the category limits isn’t required for most investors. Having an understanding of where the borders may lie can assist those who seek to allocate by market capitalization, however.

Small Beats Large

Over the long term, shares of small companies have realized higher returns than those of large companies. The discovery of this anomaly is credited to Rolf Banz and his 1981 Journal of Financial Economics study. Data compiled by French shows that the smallest 30% of exchange-listed stocks (based on NYSE breakpoints) realized an annualized return of 14.9% between 1927 and 2016. In contrast, the annualized return for large-cap stocks is 10.3% over the same period.

Some observers allege that the small-cap premium has disappeared since its discovery by Banz. The argument is based on the fact that since 1981 (and through year-end 2016) small- and large-company stocks realized returns of 11.8% and 11.7%, respectively. What the argument doesn’t tell you, however, is that so far this century, the small-cap premium has returned. Between 2000 and 2016, small-cap stocks have realized annualized returns of 10.3% versus 6.8% for large-cap stocks.

Like any anomaly, the small-cap premium does not work every year. During the past 90 years, small-company stocks have realized higher calendar-year returns just 54% of the time (49 years versus 41 years). The long-term outperformance reflects the greater magnitude of upside price movement by small-company stocks.

Small-Cap Stocks Are More Volatile

The trade-off for the higher return of small-cap stocks is greater price volatility. Small-cap stocks have historically incurred bigger price fluctuations than large-cap stocks.

Due to the characteristics of smaller companies, the higher volatility is not unexpected. Smaller-capitalization companies are less likely to be diversified across several lines of business than their larger competitors. They are less likely to be industry leaders, though many may be the leader in a niche part of their industry. To the extent that smaller companies sell components to be used in products sold by larger companies, they have less ability to influence end-market demand. Likewise, to the extent that their size puts them at a competitive disadvantage, small companies’ revenues and earnings will be more influenced by business conditions.

Notably, the 2016 SBBI Yearbook (Duff and Phelps, 2016) says “the greater risk of small-cap stocks does not…fully account for their higher returns over the long term.” Other factors could play a role, such as liquidity (large investors cannot easily allocate the same dollar amounts to small-cap stocks as they can to large-cap stocks), more opportunity for mispricing due to a comparative lack of analyst and media attention and/or investor perception. To the extent that small companies are perceived as being riskier, their share prices are more likely to lag when investors seek more stability and less economic sensitivity. They benefit when investors feel more confident in being more aggressive or seek alternatives to large-cap stocks.

Allocating by Market Capitalization

The long-term data shows a return advantage to investing in small-cap stocks. The price volatility and periods of underperformance can make it difficult for an investor to consistently stay allocated to small-cap stocks, however. For those investors who get unnverved by volatility, an argument can be made for diversifying by market capitalization.

The 2016 SBBI Yearbook shows small-cap stocks having a 0.80 correlation with large-cap stocks over the period of 1926 through 2015. Measured over the shorter period of 1972 through 2015, the correlation is 0.73. Both numbers imply that while large-cap and small-cap stocks often move in the same direction at the same time, this is not always the case. In 2001, small-company stocks gained 38.1% even though large-company stocks fell by 6.4%. The magnitude of the moves also can differ, as occurred in 2014 when large company stock returned 13.1% while small-company stocks were barely positive, with a 1.3% return.

An argument can also be made for simply being market-cap-neutral in investment decisions. Such a stance bases investment decisions solely on the attractiveness of the stock regardless of its market capitalization. In order to follow such a strategy, an investor needs to be willing to consider the broad universe of exchange-listed stocks as opposed to merely limiting the universe of potential candidates to solely large- or small-cap stocks.

—By Charles Rotblut, CFA, Editor, AAII Journal

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