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Dr. Tim Edwards, from S&P Dow Jones Indices, explains how simply put, smaller companies have more potential for growth...



RP: If you asked people to name some publicly listed stocks, they’d be likely come up with the same sorts of companies: Amazon, Apple, Facebook, and so on.

But the vast majority of stocks listed on stock markets around the world, you’ve probably never heard of.

Here’s Dr. Tim Edwards from S&P Dow Jones Indices.

TE: There’s about 11,000 stocks worldwide that are listed. The biggest single market is the US with around 4000 stocks, and the distribution of sizes there is really, really broad.

There’s a small select few that are very, very big; and then there’s a very, very long tail. There’s much more companies that are half, a quarter, a hundredth as large – all the way down to companies that are perhaps a million, or a couple of millions, in valuations. They’re also listed on the exchange.

RP: There’s academic evidence to show that it makes sense for investors to have exposure to mid-cap and small-cap stocks — in addition to so-called mega-stocks.

Simply put, smaller companies have more potential for growth.

TE: You can get a lot of what they call the equity-risk premium – i.e. a return from investing in the stock markets. You can get a lot of that by just focusing on large companies and, in fact, because there are some that are so large, they actually capture a lot of the overall market. However, if you’re interested in companies that have better growth prospects, then you might need to look beyond the largest.

So Apple is currently the largest member of the S&P 500; and I pick it because, over the last twenty years, it has been an astonishing success story. Its return is over 100 times that of the benchmark in that period. The S&P 500 went up just over three times; Apple just over 30,000 times. Now: well done, Apple. Is it possible that could happen again in the future? It’s almost impossible that it’ll happen to what’s already the largest company. But among one of those smaller companies, there may very well be one of those success stories.

RP: Despite the case for diversifying across different sizes of stocks, most investors tend to focus on the largest ones.

European investors are particularly biased towards them.

TE: If you look at European fund investors, they have almost no exposures to stocks in the mid and small-cap space. Vast majorities in this S&P 500 space. Part of that could be because of a lack of expertise, a lack of opportunity. It’s a lot easier to invest in a large-cap fund. That is changing, and I think ETFs have played a big role in that. Nowadays, you have potentially quite liquid, quite easy, quite low-cost ways to invest in mid and small-caps. Not just in the US, but across the world. So I expect it to change. But certainly, as we look at it right now, many investors, when they invest internationally, focus on the large-cap space and that may not be taking advantage of the full opportunity set they have.

RP: In short, large-cap index funds are a sensible investment over the long term.

But you might do better by investing in smaller companies as well.

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