Tilting Toward Small and Mid Caps

One interesting feature of free market capitalism is that wealth tends to get distributed unevenly, according to what's known as a power law or Pareto distribution. That means that a disproportionate amount of money ends up in a small number of deep pockets.

Pareto distribution in the stock market: 2% of the firms get about half of investors dollars. You can see this at work in the stock market just by looking at a few indexes. The U.S. market contains thousands of publicly listed companies, but it only takes 100 big ones (listed in the S&P 100 index) to account for 45% of the total market capitalization.

If you increase the number of companies ten-fold, the market capitalization just about doubles (that's the Russell 1000 index, with about 90% of the total market capitalization).

The shaded area below the Russell index includes thousands and thousands of companies - over 80% of the total - but only about 10% of the total market capitalization.

What this means is that if you buy shares of a total stock market index like the Wilshire 5000, a disproportionate amount of your investment will actually end up in a relative handful of stocks. That violates one of the goals of diversification (to minimize the effect of any one company's fortunes on your own wealth) and it's one reason to buy extra shares of small and mid cap stocks.

A second reason is that small caps have historically done better than the market. This reason may be less important than the first; if you check the historical performance you'll see that the "small advantage" is a lot less compelling than the "small value advantage."

Reasons Not to Tilt

There are also good reasons not to tilt: small and mid cap indexes are more volatile and less tax-efficient than a total stock market index, and often carry higher management fees,. That means the decision to tilt (or slice and dice as it's also called) is not an obvious no-brainer: it involves tradeoffs, and requires a judgment call on your part.

Easy Tilting Options

Most index funds offer small and mid cap choices. You can also get funds that include both small and mid caps: the Wilshire 4500 index and the S&P Completion index give you the TSM exluding the S&P 500. With these choices you lose a little bit of purity (they contain the few large caps that aren't included in the S&P 500); there is also some debate about whether they will be more or less tax efficient than separate small and mid cap index funds. (The "more" argument: since the S&P 500 and the TSM are both tax-efficient, it seems like their difference ought to be, also. The "less" argument: it hasn't always worked out that way. Another judgment call here.)


Article Contents
Index Basics
Size, Growth, Value
Dangers of Timing
Portfolio Guidelines (1)
Adding Small & Mid
Adding Foreign Funds
Portfolio Guidelines (2)
List of Funds & ETFs
Books & Links

Article Contents
Why Index?


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