The Rules of the Game: Include Small Caps

 | Apr 01, 2013 | 5:00 PM EDT  | Comments
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Conventional wisdom -- which is not always so wise -- holds that investors should switch into stock-avoidance mode when indices are rallying.

To that I ask, "Whaaat?"

During the years when I was a trading coach, I repeatedly warned people about the perils of buying into a stock that was extended from its technical buy point. When trading in and out of stocks with the hope of landing a legendary winner, the notion of a stock being extended is critical.

But for investors with a longer time horizon, the view of timing is a bit different. I understand that nobody wants to buy a stock at the peak of a rally, and then see it declining as the general market pulls back.

However, as I noted in a recent column, the aversion to buying high often translates into a misguided desire to sell when an investor thinks a market may be topping. (And usually, he or she gets that idea from a pundit in the media somewhere.)

So as you may have guessed, I'm not going to be giving you trading ideas today. Or pretty much ever, since my perspective has evolved from that of a growth trader into one of a more diversified investor.

At Portfolio, we continue to have the view that markets have upside potential in 2013. Will there be pullbacks? Certainly. Does that mean you should panic and start hitting the "sell" button? Absolutely not.

We are not bailing out of stocks due to market highs. On the contrary, we continue to hold a carefully selected group of ETFs, though we do rebalance on a regular basis, taking market conditions into account. And contrary to those who believe a market correction means to run breakneck into cash, we view pullbacks as buying opportunities.

I've written recently about some one of our holdings, the WisdomTree Emerging Market Small Cap Fund (DGS), and explained some of the reasons we are putting clients into that fund.

In some of our moderate portfolios, we have put clients into the Vanguard Small-Cap ETF (VB).

This ETF offers a low-cost exposure to domestic small caps. It's a suitable complement to domestic large-cap equities, with solid diversification across the value and growth categories, as well as sectors.

But it's important to limit exposure to small caps, given their greater propensity to volatility and their proportion of the larger market's make-up. In some of our moderate portfolios, the VB accounts for about 12% of the total holdings.

When it comes to small caps, keep this in mind: Smaller companies are often more volatile for several reasons. U.S.-based small caps typically do most of their business domestically, therefore having limited growth opportunities to faster-growing markets overseas. The downside to that is a greater sensitivity to U.S. economic cycles, and perhaps less competitive advantage over larger, well-funded rivals.

On the other hand, their smaller size can make these companies more nimble. Often, even publicly traded small caps are essentially family businesses, meaning the decision-making process can happen quickly. That's a plus when it comes to rolling out new products, services, or marketing campaigns.

VB is pegged to the MSCI U.S. Small Cap 1750 Index. I used the term "low cost" above to describe this fund because it has an expense ratio of 0.10%. While the expense ratio should always be factored into your investment decisions, don't consider it in a vacuum. Instead, consider that within an overall view toward the investments that would provide the best diversification for your portfolio.

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