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Artificial intelligence doesn’t appear to be going anywhere, which is why stock in companies that stand to benefit from the technology’s rise continues to shine. Microchip giant Nvidia has been the banner name, having returned an eyewatering 1,904% over the past five years.

But while Nvidia and the A.I. revolution have dominated headlines, you’d have earned more by investing in cosmetics firm e.l.f. Beauty. Over the same period, the stock returned 2,491%. Those invested in cloud computing company Super Micro Computer did even better, with a return of 4,175%. Energy drink maker Celsius Holdings posted a half-decade return north of 5,300%.

If you haven’t seen much of these stocks in financial headlines, you’re not alone. Nvidia’s meteoric rise has made it one of the most valuable companies in the world. It’s now the third-largest stock in the S&P 500, trailing only Microsoft and Apple.

Celsius, Super Micro Computer and e.l.f., meanwhile, still aren’t big enough to be among the market’s largest 500 companies. That means they’re not only less likely than bigger stocks to be covered by the press, but also less likely to be in your portfolio if it’s centered around the S&P 500 or similar large-company stock indexes.

In fact, all three stocks have market capitalizations, which is the share price times shares outstanding, that classify them as mid-cap — a portion of the market that analysts at S&P Dow Jones Indices call a market “sweet spot.”  

“For the most part, mid caps have consistently outperformed large caps over various timeframes,” including both sustained up and down markets, the analysts say in a note.

Why smaller stocks tend to outperform larger ones

It’s not hard to picture how small companies can have a growth advantage over large ones. A stock that costs $1 a share needs to get to $4 to realize a 300% return. Imagine what it would take for a large, financially mature company like Microsoft to quadruple in size.

That’s why investors who are looking to boost their long-term returns over time — especially those currently heavily concentrated in large stocks — are encouraged to diversify into small- and mid-cap stocks.

“You want partake in the success of the U.S. economy,” Jeremy Straub, founder and CEO of financial advisory Coastal Wealth told CNBC Make It. “That means businesses that are in the U.S. at all parts of that businesses lifecycle — when they’re starting out as a smaller size company, up to the big behemoths that we know as household names.”

Ideally, you want to own a stock when it’s still a minnow and ride the stock price all the way up to when it’s a market-leading whale.

If you pick one stock to ride with, it can be a risky plan. After all, for every company that starts in someone’s garage and ends up as a multinational, there are countless others that fade into obscurity.

“You don’t want to be buying into some random company hoping it becomes the next Amazon,” says Greg Marcus, managing director at UBS Private Wealth Management. “Smaller companies generally experience more volatility.”

That’s why it might make sense to hold small- and mid-cap names in a broadly diversified mutual fund or exchange-traded fund. You won’t get the sky-high returns you could enjoy from owning a single big winner, but you won’t have to deal with huge single-stock losses either.

And historically, it’s paid to own some smaller names alongside your core large-cap portfolio.

In an analysis of foreign and U.S. investments from December 1998 through June 2023, researchers at index provider MSCI found that small-cap stocks outperformed large firms over 15-year periods about 9 in 10 times.

For any 10-year period over the two decades ending September 2023, you’ll find that mid-caps outran both large- and small-caps 60% of the time, with less overall volatility than larger stocks, according to data from Hennessy Funds.

How to add small and midsize stocks to your portfolio

You may be wondering if it’s worth buying the top performing small- and mid-cap stocks or going on the hunt for the next one. Both are probably a bad idea, says Christine Benz, director of personal finance and retirement planning at Morningstar.

Many investors lack the tools to properly analyze a company’s fundamentals, she says. Plus, devoting too much of your resources to any single stock increases the risk that poor performance could hurt your whole portfolio.

“That’s the beauty of exchange-traded funds and mutual funds,” Benz says. “They let you pick up a lot of diversification in a single shot.”

If you’re building a portfolio, one way to make sure you’re exposed to smaller-company stocks is to buy a total market index fund or ETF. Funds tracking the CRSP US Total Market Index, for instance, grant access to just about every stock available on the market, with the highest weightings given to the biggest stocks.

If you already own a large-company stock fund, such as one tracking the S&P 500, you can up your exposure by adding index funds and ETFs that track small- and mid-caps. Just be sure to stay within the same family of indexes, since different benchmarks have different parameters for market sizes.

Index funds investors can find Celsius in both the iShares Core S&P Mid-Cap ETF as well as the Vanguard Small Cap Index fund. Indexes in the same family are usually mutual exclusive in their holdings. Buying complementary funds that track them, you ensure that you’re not doubling up on a particular investment or leaving another one out.

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