Equities have long served as a cornerstone of successful long-term investment strategies. When incorporated into well-structured financial plans, stocks have demonstrated their ability to build wealth and help investors reach their financial objectives over time. Yet an important consideration emerges: which types of equities should investors consider? While market commentary and investor attention often gravitate toward the shares of the largest corporations, numerous other segments can serve vital functions in well-diversified investment portfolios.
Market discussions frequently center around major indices like the S&P 500 or Dow Jones Industrial Average. The S&P 500 represents an index capturing the performance of 500 of the largest publicly traded corporations, organized by market capitalization as a measure of company scale. Meanwhile, the Dow encompasses just 30 large, established enterprises. Both indices predominantly feature companies that are incorporated and based in the United States.
Given their construction methodology, these benchmarks concentrate exclusively on America's largest corporations. This focus proves valuable for gauging broader market and economic trends, as the largest companies typically influence these patterns. Nevertheless, when constructing investment portfolios, these indices may miss other promising opportunities. This consideration becomes particularly important when a select group of "mega cap" companies, including members of the Magnificent 7, have primarily driven both gains and losses.
Given this market landscape, how might investors expand their investment outlook? Small-cap equities and international markets represent two examples of segments that can offer opportunities and diversification benefits. Each presents unique characteristics and potential advantages that can strengthen portfolio diversification, particularly during periods of market turbulence and economic uncertainty.
Small-cap stocks have underperformed but provide diversification advantages
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Small-cap equities encompass companies with market capitalizations generally spanning from several hundred million to a few billion dollars. This differs from mid and large-cap enterprises that range from tens to hundreds of billions, while mega caps now reach valuations in the trillions.
The Russell 2000 index, which measures small-cap performance, has delivered 5.2% annualized returns over the past decade versus 10.9% for the S&P 500, as illustrated in the accompanying chart.1 This performance differential has been especially notable in recent years as market concentration among large and mega cap companies has grown, particularly within technology and artificial intelligence-focused sectors. Small-cap enterprises typically maintain less technology sector exposure and generate more revenue from domestic operations, making them responsive to shifts in U.S. economic policy and trade conditions.
Importantly, small caps have faced challenges this year amid continued uncertainty regarding tariffs and economic expansion. However, this has resulted in potentially appealing valuations. Small-cap stocks currently trade at more reasonable price-to-earnings multiples relative to large-cap stocks. The Russell 2000 presently maintains a price-to-earnings ratio significantly below its 10-year average. Even more notable is the price-to-book value of approximately 0.8x, substantially below the historical average of 1.2x. By contrast, many S&P 500 valuation measures stand well above average, approaching historical peaks in some cases.
The interest rate landscape represents another significant distinction between large and small-cap companies. Small caps frequently depend more heavily on floating rate debt financing than their large-cap peers, creating greater sensitivity to interest rate movements. While this presented difficulties when rates climbed rapidly starting in 2022, the more stable environment since then could prove beneficial. This becomes particularly relevant if the Fed proceeds with additional rate cuts later this year.
Many of these indicators suggest that small-cap stocks offer more attractive valuations than numerous other market segments. While large caps will maintain their important portfolio role, this underscores the availability of opportunities across various market areas.
International markets remain attractively priced
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International equities present another area of compelling valuations, generally divided into two primary categories: developed markets (including Europe, Japan, and Australia) and emerging markets (encompassing countries such as China, India, and Brazil). These distinctions reflect variations in economic development, market infrastructure, regulatory environments, and additional factors.
While U.S. stocks have dominated global markets throughout much of the past decade, international equities have outperformed this year. The MSCI EAFE index, which follows 21 major developed market countries, has advanced approximately 17.3% year-to-date in U.S. dollar terms. The MSCI EM index, tracking emerging markets, has increased 8.9%.2 This performance has occurred despite global uncertainty stemming from trade concerns.
Beyond superior performance this year, valuation disparities remain significant. While the S&P 500 trades at elevated price-to-earnings multiples, international markets present more attractive valuations, as demonstrated in the chart above. This partially results from political and economic challenges across many regions over the past decade, some of which have started to improve.
A key distinction between U.S. and international investing involves currency fluctuations affecting returns. The weaker dollar has particularly created favorable conditions for U.S.-based investors. Foreign assets gain value when their denominated currencies strengthen, enabling conversion back to additional dollars. This currency benefit has meaningfully contributed to international stocks' strong performance this year, providing extra support beyond the fundamental performance of foreign companies.
Diversification across regions and market capitalizations remains crucial
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For long-term investors, maintaining exposure to segments like small-cap and international stocks can help create more balanced portfolios. This becomes especially relevant following the substantial performance of large-cap stocks driven by just a few of the largest companies.
This does not suggest that U.S. large caps will diminish in importance. This also does not advocate for dramatic changes to well-designed portfolios. Rather, maintaining long-term portfolios involves holding appropriate asset allocation across all these investment types. By including more attractively valued market segments, we can potentially enhance long-term risk-adjusted outcomes and capitalize on market opportunities. While individual asset classes may underperform during certain periods, their varying characteristics and return patterns can deliver valuable diversification benefits over time.
The bottom line? While the S&P 500 and Dow remain significant benchmarks, investors should evaluate the advantages of diversifying across numerous other market segments, including smaller companies and international stocks. Maintaining suitable portfolios for the long term continues to represent the optimal approach for achieving financial success.
Notes:
1. Russell 2000 and S&P 500, price returns, from January 2, 2015 to May 30, 2025
2. MSCI EAFE and MSCI EM, total returns, January 1, 2025 to May 30, 2025