Revealed: Risk-reward myth shattered

Large cap companies beat small cap companies each and every time: short-term, long-term, and after market trauma.

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Blue post-it note with 'myths' written on it next to pink post-it note with 'facts' written on it

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Traditional investment wisdom says the greater the risks you take, the higher the potential returns (and losses).

And in the share market, large and small capitalisation companies roughly equate to the lesser and greater risk investments, respectively.

Larger companies are more established players in their sector and are likely to have more reliable and steady revenue streams.

Smaller players may have more volatile revenue streams but are at a stage when their fortunes can skyrocket (or fall off a cliff).

But recent research has revealed the old risk-reward relationship might just be a myth, at least on the ASX.

Large caps beat small caps, every time

Sydney research firm Foresight Analytics has revealed that over the last 2 decades, large cap companies have outperformed smaller rivals.

And this is seen both over the short-term (last 3 years) and over the entire 20-year timeframe.

Timeframe
(to 30 June 2020)
Large cap return
(% pa)
Small cap return
(% pa)
1 year (5.1) (3.71)
3 years 7.89 5.27
5 years 8.43 6.55
10 years 8.88 5.09
20 years 8.74 6.37
Source: Foresight Analytics, table created by author

Foresight Analytics managing director Jay Kumar told The Motley Fool that in Australia a few very large companies hog most of the investor capital.

“If you look at the weighting structure… it’s heavily concentrated in the top 10, top 15 names. And also heavily concentrated in two sectors — financials and resources.”

This means the smaller players are starved of available capital. And less demand means lower returns for the small caps.

Another theory is that compulsory superannuation in Australia contributes towards more conservative investment in the local stock market.

Large caps recover better after market crashes

Another surprise against conventional wisdom is that large cap companies recover their share price faster after a market crisis.

According to Kumar, investors look for companies with very specific attributes after a traumatic event.

“After a stress in the market, generally investors tend to favour liquid and large companies,” he said.

“Over the four stress periods we analysed, small companies have significantly underperformed compared to large caps, including in the first 30 to 40 days after a crisis.”

High quality companies always outperform mediocre companies that might be priced attractively.

“Exposure to quality companies provides a good hedge against market distress,” Kumar said.

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Motley Fool contributor Tony Yoo has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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