Why you shouldn't focus on the biggest stocks

Why shouldn't you focus only on the biggest stocks when you invest?

Ask most people to name a few listed companies and they'll reach for the same familiar giants: Amazon, Apple, Facebook. But those household names are a tiny fraction of the market. The vast majority of the world's listed stocks are companies you have probably never heard of, and ignoring them could mean missing out on some of the best growth opportunities available.

In this video, Dr Tim Edwards of S&P Dow Jones Indices explains why investors should look beyond mega-cap stocks and gain exposure to mid-cap and small-cap companies as well. With around 11,000 listed stocks worldwide and roughly 4,000 in the US alone, the range of company sizes is enormous, from a handful of giants down to a very long tail of far smaller businesses. The academic evidence shows there is a strong case for diversifying across different sizes of stocks, because smaller companies tend to have more room to grow.

Dr Edwards uses Apple as an example. Over a twenty year period, Apple returned more than 100 times the S&P 500 benchmark. He explains why it is almost impossible for today's largest company to repeat that feat, and why the next great success story is far more likely to be found among smaller companies. He also explains why European investors in particular tend to be heavily biased toward large-cap stocks, and how low-cost ETFs are now making mid-cap and small-cap investing easier, cheaper and more accessible around the world.

The takeaway: large-cap index funds are a sensible long-term investment, but you may do better by adding exposure to smaller companies too, capturing a fuller opportunity set and greater potential for growth.

Chapters / Key points

• Why investors gravitate toward the same familiar mega-cap stocks
• How many stocks are actually listed worldwide, and their spread of sizes
• The academic case for mid-cap and small-cap exposure
• Why smaller companies have more potential for growth
• The Apple example: why past mega-returns are unlikely to repeat at the top
• Why European investors are especially biased toward large-cap stocks
• How low-cost ETFs are opening up small and mid-cap investing
• Why diversifying across company sizes can improve long-term returns

Transcript

Why you shouldn't focus on the biggest stocks

RP: If you asked people to name some publicly listed stocks, they'd be likely to 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 4,000 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 many 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 exposure 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.