Friday, October 11, 2013

Volatility in Small Cap Stocks

I believe that it is generally taken as a given that there has been a persistent level of higher returns from small cap stocks, compared to large caps, but that this higher return is at least partially explained by higher volatility among small caps, so that the risk/reward profile for small cap stocks, measured by something like the Sharpe Ratio, is not as high as the raw returns would suggest.

Normally, in a portfolio, this distinction would be handled by matching the portfolio holding period to the risk profile of the available asset classes.  A portfolio with a longer holding period would be better able to capture the higher returns of small cap stocks because as the holding period increases, the benefit of the higher returns increasingly outweighs the cost of volatility.  If I am investing cash that I need to withdrawal in 60 days, I might expect small cap stocks to give me an average return of 2%, compared to 0% in risk free bonds.  So, the possibility of taking a 20% hit due to unforeseen volatility is not worth the risk.  However, over 20 years, small caps might be expected to give a 1000% return, compared to 100% for risk free bonds.  Over that time period, the small caps would still provide much higher returns, even if we happen to withdraw the funds during a 20% downturn.

But, I noticed something interesting, at least for the period over the 25 years.  I was looking at this chart:

The Russell 2000 is in red and the S&P 500 is in blue.  We see the slightly higher return over time from the small cap index (although, the S&P 500 makes up for this with a higher dividend).  But, eyeballing it, the Russell 2000 index looks like it might be the less volatile of the two indexes.

So, over the past 25 years, I compared the 2 indexes based on standard deviation of prices over 1 month, 1 year, 2 years, and 5 years.  This is what I found:

Over shorter holding periods, the volatility of the small cap stocks is higher than the large cap stocks, as we would expect.  But, as the holding period extends to 2 years or 5 years, the volatility of the Russell 2000 declines.  For the 5 year period, this only includes 5 data points, but the effect appears to be unaffected by the starting points of the holding periods.

If I annualize the volatility, the S&P 500 appears to have a fairly flat profile, indicating some positive serial correlation over periods less than 2 years, but generally a low level of serial dependence.  For small caps, on the other hand, there appears to be a large amount of very short term volatility, but even at short holding periods, reversion to the mean causes volatility to decline as the holding period increases.

Small caps would appear to provide better opportunities across the time profile.  For the short term speculator, they provide greater volatility.  For the long term investor, they provide comparable or superior return performance with significantly less volatility.  Across the board, small caps appear to offer superior performance for investors who are not subject to non-financial risks (such as reputational and agency issues).

1 comment:

  1. Over that time period, the small caps would still provide much higher returns, even if we happen to withdraw the funds during a 20% downturn.good stocks to buy