3 Reasons Why Small Cap Stocks Rule

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Why are small cap stocks king?

Here are three reasons why investors should love them:

1. Small Caps will survive an interest rate reversal and still earn positive returns

Small caps live and die by market conditions, but maintain solid returns over the long run. When investors discuss the benefits of CD’s and money market investments for the long-term, I find it very hard to take them seriously. They have forgotten that the Feds increased short-term interest rates to control inflation. Economists have already reasoned that the economy is slowing, so the feds have no reason to raise rates anymore. In fact, they may lower rates in their next couple of meetings because the current stock to bond ratio is nearly 3 to 1. The repercussions of this imbalance could be disastrous, and I’m sure economists are searching for a viable solution to a problem that occurs around 1% of the time.

Micheal Brush from MSN Money posts a good article on this stock to bond anomaly. These 4% and 5% rates won’t last 20 years! When these high interest rates vanish, how will CD and money market investors maintain those returns?

Since bonds and interest rates carry an inverse relationship, a bearish stock market will force billions of dollars to flow back into the bond market, thus causing interest rates to tumble. The slowing of American economic growth also contributes to lower interest rates because the demand for capital decreases. The laws of supply and demand put pressure on high interest rates, and eventually the rates begin heading south. This will all occur in the next 3 years if not in 2007.

2. The time value of money makes owning small cap stocks worth any broker/commissions fee you pay out.

Small cap stocks return 12% annually on average since the market inception, compared to 11% for large caps. To get even more technical, refer to the “real return” on investment – investments gains minus federal taxes and inflation.

Historically, small cap stocks return 5.6%, large caps 4.7%, 0.4% for bonds, -0.5% for treasury bills, and – 1% on certificates of deposit.

The data are between 1926 and 1999, marking the equity growth frame for domestic stocks (we’re excluding International equities and holdings from our dataset).

3. High Risk investments earn High Returns

I often converse with “traders” who despise holding stocks with low market caps and substantial volatility. Of course we would expect day traders to act like they know everything, but when it comes to investing, unlike trading, we are very concerned about long-term trends. We can survive the added risk and volatility if we build our stock position over the long term. As your targeted company grows, so should your holdings. That way we fully benefit from the initial discounted share purchase price through dollar cost averaging.

Small cap securities have consistently provided profitable trends over the long run, that’s why the investor who bought Microsoft at the IPO is lounging on a warm beach somewhere in Acapulco while we’re all stuck at our day jobs.

IMHO, any investor can become that lucky guy especially since buying stocks is so easy nowadays. Discount brokers like ShareBuilder are perfect for small time investors and/or financial experts. Where else can you buy any virtually stock, reinvest shareholders dividends for free, trade options, and track gain & loss reports for as little as $2 a trade? We investors should take advantage of the recent letup in commission fees and aim towards our financial goals. Wal-mart was once a small-cap, so was Microsoft, Google, Disney, and any other major corporation you can think of. We want to buy them before they become household names. With proper research, intuition, and sometimes a little luck (never hurts), you can uncover the next Microsoft and become very, very wealthy.

Small caps are the perfect recipe as long as we’re comfortable with the added risk.

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