The stock market is on fire. It's surging upward to challenge the record highs set at the start of August. It will not be surprising if these highs are taken out by the end of the year.
I bet by this point, many readers are thinking: "What, have you lost your mind?! The government shutdown has knocked the stock market off its bullish run. All investors can expect now is more gloom and doom."
Well, despite the selling, I stand by my bullish words. Let me explain.
I entered 2013 in a super bullish mood, and I remain super bullish on the market even during this cyclically bearish time of the year. In my opinion, worries of Federal Reserve tapering and its effect on the market are largely overblown. (I recently explained several of the reasons for my continued bullishness.)
Taking a look at the weekly chart of the Dow Jones Industrial Average, it's easy to see the bull run remains fully intact despite the several-week sell-off. The DJIA has surged from around 13,500 at the start of the year to 15,709 three weeks ago -- a massive 2,200-plus point gain in just over nine months. Although the Dow has dropped about 700 points over the past three weeks, price remains above the 50-week simple moving average and in a clear uptrend for the year.
Long-term stock market investors are thriving in this bullish environment -- but though the broad market is up sharply on the year, a certain segment has outperformed it by an impressive margin.
Some investors consider this market segment to be too risky for investment; others may simply not be aware of this sector's proven outperformance. While there may be more inherent volatility in this market segment, the outperformance more than makes up for the volatility.
In addition, there is a way to mitigate the risk of investing in this market segment. Not only will this investment help reduce the risk of choosing individual stocks within the segment, it can help reduce the volatility of your portfolio. I am talking about the small-cap segment of the market.
Small-cap stocks have readily outperformed the broader market over the past decade. The reasons for this are many.
The primary reason is that growth and innovations remain firmly in the small-cap space. When companies outgrow their small-cap status, they often become focused on simply maintaining the status quo rather than innovating. Although there are multiple exceptions to this rule, overall it remains accurate.
In addition, history shows that smaller, faster-moving companies have repeatedly risen up to challenge the bloated, established firms in nearly every industry. It is this driving competitive nature of the small caps that excites and attracts investors, who in turn push share prices higher.
Finally, as a practical point, it's easier for small stocks to double and quadruple in value than it is for their big-dollar brethren.
Despite the outperformance, we all know that small caps are generally more volatile and thus riskier than companies with larger market caps. How can an investor capture the upside of small caps while mitigating the risk factors?
The primary way to do this is by diversification across a wide swath of the small-cap marketplace. Fortunately, individual investors no longer have to design their own small-cap portfolios to obtain this critical diversification. Exchange-traded funds, or ETFs, provide investors exposure to the segment in the form of professionally designed diversification within the segment.
My favorite ETF in the small-cap space is the iShares Core S&P Small-Cap ETF (NYSE: IJR). No small-cap investment itself, the fund boasts $11 billion in assets spread across 603 small-cap stocks. Most appealingly, the ETF does not concentrate risk into any small-cap sector or individual name. Every holding takes up less than 0.7% of the fund's assets; the top 10 holdings account for less than 6% of the total assets. IJR is up about 21% this year, with a three-year average return of just under 23%. The returns have consistently outperformed the S&P 500 Index over the past three-, five- and 10-year periods.
As icing on the cake, this ETF yields a modest annual dividend, about 1.4%. IJR's performance has been strong enough to earn it the Morningstar Award for ETFs in the Small Blend Institutional category.
Risks to Consider: Small caps are notorious for high volatility, though this ETF mitigates that volatility somewhat. Always use stop-loss orders and position size properly when investing.
Action to Take --> I love this ETF on a breakout above $99. Stops at the technical resistance level just below $94 and a 12-month target price of $135 create powerful risk/reward potential.