Saying why mid-caps have behaved as they have doesnt explain why theyve done such a good job of diversifying a large-cap-heavy portfolio, though. The answer lies in small caps horrible risk/return profile. You diversify in order to squeeze the highest amount of return out of your portfolio for a given level of risk. Small caps delivered more volatility than mid-caps during the past 20 years, but actually offered lower returns. An asset could have a high level of volatility but still lower a portfolios risk if it gained money when other assets were in the red. For the 20-year period that we examined, though, small caps ability to zig when large caps zagged wasnt enough to compensate for their greater volatility.
Small-cap boosters would argue that their stocks might look more attractive if we studied a more-hospitable time span. In all fairness, then, lets suppose that small caps risk profile and their diversification from large caps remain the same going forward, but that small-cap returns improve. The question then becomes: How much more would small caps have to return over mid-caps to be the diversifier of choice, given the greater volatility of small caps? The answer: Small caps would have to outperform mid-caps by more than 2.4 percentage points per year. Thats certainly within the realm of possibility. Indeed, it has happened before.
How to Use Mid-Caps >>