$iShares Russell 2000 ETF(IWM)$  

Small-cap stocks have the potential to maximize returns

The best reason to invest in small-cap stocks is their greater potential to deliver outsized returns compared to larger companies. For instance, it's considerably easier for a $1 billion company to become a $10 billion one than it is for a $100 billion company to grow to $1 trillion. In fact, some of the biggest companies in the world once traded in the small-cap range, such as Amazon (AMZN 2.68%) and Netflix (NFLX 1.43%). If you had bought and held these stocks when they were small, you would have seen your initial investment appreciate more than 100 times.

Small-cap stocks tend to have higher growth rates. Again, it's easier for a smaller company to double its revenue; mature companies tend to see slowing revenue growth. However, small caps are also more likely to be unprofitable. This makes them more volatile than large caps because they are more vulnerable to recessions, market crashes, and other shocks. For example, during the 2020 crash, when the COVID-19 pandemic hit the U.S., small-cap stocks fell more than their large-cap peers.

Additionally, small-cap stocks are followed by fewer investors and Wall Street analysts, so they often have bigger swings on news such as earnings reports.

Due to their higher volatility, small-cap stocks tend to outperform during young bull markets when stocks are quickly moving higher. For example, since the Russell 2000, which tracks the performance of small-cap stocks, bottomed out on March 18, 2020, it's outperformed the much larger S&P 500 by a significant margin, as the chart below shows.

However, you'll notice that since the bear market in the Russell 2000 began on Nov. 8 2021, the small-cap index has underperformed its large-cap peer, showing how volatility swings both ways.

It's also worth noting that in the heady days of the bull market following the 2008-2009 financial crisis, the Russell 2000 outperformed the S&P 500 by a wide margin. The chart below shows the first year of that bull market.

In fact, the Russell 2000 would outperform the S&P 500 for most of the decade after the financial crisis. Smaller companies also benefit from such accommodative monetary policies as low interest rates, which make it easier for them to borrow to expand or keep their businesses afloat during tough times. Similarly, fiscal stimulus programs are also beneficial for small-cap stocks since they're generally more sensitive to consumer spending and market sentiment.

On average, small-caps have an advantage when the U.S. economy is in recovery mode. When the economy is rebounding, unemployment rates are quickly going down, and businesses are seeing strong earnings growth, making it a great time to invest in small-cap stocks

Of course, small-cap stocks don't always outperform. Just as these stocks have more upside potential, there's also substantial downside risk since they're less likely to be profitable and can more easily be pushed into bankruptcy. That makes small-cap stocks riskier than so-called blue chips. But with greater risk comes greater potential for reward.