Are Small-Cap Stocks Riskier? Small Caps vs the S&P 500 in Every Crash Since 2008

Cap is short for market capitalization, the total value of a company's shares. Large caps are the giants that dominate the S&P 500. Small caps are companies worth roughly a few hundred million to several billion dollars: regional banks, smaller manufacturers, retailers, biotech firms and thousands of businesses most people have never heard of.

Two indexes are the usual way to own them. The Russell 2000 holds the smaller two thousand of the three thousand largest US companies, and is tracked by the IWM fund. The S&P SmallCap 600 holds fewer companies and adds a test the Russell 2000 does not: a company generally needs a record of positive earnings before it is added. It is tracked by the IJR fund. That one rule turns out to matter.

Over the months the S&P 500 fell from its peak to its bottom in each crash, here is how the two small-cap funds moved.

In the 2008 financial crisis the S&P 500 fell about 56% and the Russell 2000 about 59%. In the late-2018 selloff the gap was wider: about 20% for the market against about 26% for small caps. In the 2020 COVID crash the S&P 500 fell about 34% and small caps about 41%.

In 2022 the Russell 2000 ended the window about level with the market, down about 26% against about 25%, though its lowest point along the way was a little deeper, about 27%. On this record, the reputation holds: in three of four crashes small caps fell clearly further, and in the fourth they did not fall less.

The second half of the reputation is the faster rebound, and here the record is mixed. After 2008 it held: the Russell 2000 got back to its old price high about 25 months after the bottom, against about 48 months for the S&P 500, roughly half the time, even though it had fallen a little further.

After every crash since, it went the other way. After the late-2018 selloff the S&P 500 was back at its high in about 4 months, while small caps took about 23 and only got there after the 2020 crash had come and gone. After 2020 small caps took about 8 months against about 5, and after 2022 about 28 months against about 15, as the largest companies led the market back up.

Small companies usually have less of a cushion. They tend to rely more on borrowing, often at rates that rise when the central bank raises its rate, and they have fewer ways to raise money when lenders get nervous. Many sell mainly in one country or one product line, so a recession at home hits them directly. And a larger share of small companies are not profitable at all, so they depend on credit staying open and on investors staying patient.

Big companies are not immune to any of this, but in a panic investors tend to sell what looks fragile first and hold on to the firms with large cash piles and steady profits.

The two small-cap funds tracked each other closely in 2008, 2018 and 2020. They split in 2022. The S&P 600, with its earnings test, fell about 23% over the window, less than both the Russell 2000's 26% and the S&P 500's 25%, and it got back to its old high in about 22 months against about 28 for the Russell 2000.

2022 was a year of sharply rising interest rates, which hit companies without profits hardest, because their value rests on earnings far in the future and they need to keep borrowing to get there. One crash is not proof of a rule, but it is a reminder that a small-cap fund is a set of rules about which companies get in, and the rules shape the ride.

The long-run case for small caps is the size premium: studies of decades of US data found that small companies earned more than large ones on average, partly as payment for the extra risk. The premium has been far from steady. Over most of the years since 2010, large companies, led by technology, have generally outpaced small ones, and there have been other long stretches where small caps lagged.

You also already own small caps if you hold a total-market fund. They make up only a small slice of it, because the fund weights each company by its size. A separate small-cap fund is a tilt on top of that.

The useful question is not whether small caps are good, but what a small-cap tilt would do to your mix. Backtest your portfolio as it is and with a slice moved into a small-cap fund, and compare the maximum drawdown, the recovery time and the total return over the whole period. Then replay both versions through 2008, 2020 and 2022 in the stress test, and try the same tilt with each of the two indexes.

Educational, not advice: whether small caps belong in your portfolio depends on your goals, your horizon and everything else you own.