When it comes to investing in the stock market, one of the most popular ways to find and choose suitable investments is to focus on the three market-capitalization categories: small, medium and large.

These broad groupings of stocks avoid the overspecialization that the proliferation of new stock indices can produce. They can also help focus on the strongest parts of a market, because one of the size groupings is always outperforming the others. And if one of the categories is performing well, that would obviously be the ordinary investor’s preference.

The size factor comes into play in when you consider your clients’ investment preferences, whether they are ultra-conservative or a risk-taking growth seeker. Big-cap stocks tend to be stable and higher-priced, whereas small-cap stocks tend to be volatile and lower-priced. Large-cap stocks mostly pay dividends, while small-caps are less likely to pay them.

Mid-cap stocks, of course, come in between in their size, volatility and dividend payments. However, their performance is not always in the middle because they sometimes lead, or lag, the other two categories.

One of the difficulties with this type of investment strategy is determining what stocks really are large, medium or small. The extremes are easy: we know General Electric Co. and Exxon Mobil Corp. are mammoth companies; and we can surmise that, say, Napier Environmental Technologies Inc., which is trading in pennies, is probably pretty small.

The most widely known “size” collections of stocks on Wall Street are the Standard & Poor’s Corp. and Frank Russell Co. indices. In Canada, it is the S&P/TSX index series. The range between largest and smallest capitalizations within these indices is great — especially in the U.S. S&P indices — and overlap with other size ranges.

Average market capitalization and median capitalization within these indices are a better guide to relative size, as the accompanying table shows.

Such comparisons detail the size differences among Canadian (S&P/TSX) mid-cap and small-cap and U.S. (S&P) indices. Yes, the large U.S. stocks are larger, but the smaller U.S. index stocks are not really that much larger than their Canadian counterparts.

The three U.S. S&P indices account for about 92% of U.S. stock market value. They do this counting only 1,500 stocks.

The Russell indices are sweeping. The basic index is the Russell 3000, which is made up of the 3,000 largest U.S. stocks, accounting for 98% of U.S. market value. The Russell 1000 index takes the largest 1,000 stocks from the 3,000. The Russell 2000 index, regarded as a small-cap index, holds the remainder of the 3000. The Russell mid-cap index is a slice of the Russell 1000 index — the smallest 800 stocks within the Russell 1000.

The Russell organization has also added a micro-cap index, which consists of the 1,000 smallest stocks in the Russell 3000 index plus an additional 1,000 smaller stocks, meaning the Russell reach extends to 4,000 companies.

Membership of the S&P indices changes gradually, while the Russell indices are reconstituted each year.

Small-cap indices have the largest returns over the long haul, but they also have the highest losses.

As the great bull market expired in 1999-2000, large-cap stocks lost their place as the strongest segment of the market. And small- and mid-cap stocks started to outperform the large-caps.

In Canada, however, investor preference has changed recently in favour of large-caps; they have been the strongest area of the market since early 2005, thanks to the strong performance of resources and financial stocks.

However, in the U.S., that hasn’t been the case. S&P’s mid-cap and small-cap indices reversed upward in 1999 and have outperformed the large-cap S&P 500 composite index ever since. As of mid-2001, the S&P small-cap index has gained 67% vs the mid-cap index’s 51.9% and the S&P 500’s 7.7%.

In 2005, the S&P mid-cap index beat the others, gaining 11.3%, with the small-cap index up 6.7% and the S&P 500 up 3%.

The small-cap Russell 2000 index started its outperformance on Wall Street in October 1998. Since then, the index has risen 93.2% on a monthly closing basis, while the large-cap Russell 1000 index gained only 22.2% in the same period. But the top performance came from the Russell mid-cap index, which was up 100.2%.

This year, however, the Russell 2000 has become the strongest-performing index among the three. It gained 7.9% in the first 10 weeks of 2006, with the mid-cap index up 4.4% and the Russell 1000 up 2.6% during that period.

@page_break@The relative performance of Canadian small stocks dropped heavily as the long bull market ended. In 2001, the reversal began — the new S&P/TSX small-cap index began to outperform. This index reached a peak at the end of 2003, but it has been underperforming the market since.

The new S&P/TSX mid-cap index also started to revive in 2001, climbing to a relative performance peak in March 2005. However, since then, the large-cap S&P/TSX 60 index has been the strongest of the three. IE