Don't overlook investing in small-company funds

If you tend to pass over small-company stock in favor of the large, better-known companies in the Standard & Poor's 500 index, now is the time to change your attitude about investing.

During most of last year, the stocks of large, well-established companies rose in value. That was good news for federal employees who had placed some or all of their Thrift Savings Plan (TSP) dollars in the common stock, or C fund. The C fund is an index fund that replicates the performance of the S&P 500, which is composed of the 500 largest companies in the countr

However, beginning late last year, the S&P 500 started moving sideways, and so far this year it has dropped a few percentage points. Meanwhile, the stock value of smaller companies has been going through the roof.

This development is not surprising because historically, small-company stock tends to outperform large-company stock. It is virtually impossible for large companies to grow as rapidly as smaller companies.

Admittedly, large companies run into fewer setbacks because they are well-established in the market and have loyal customers. Small companies must compete aggressively to achieve the reputation that companies in the S&P 500 have attained. Successful small companies often appreciate significantly in value, while those that fail are either bought out by competitors or go out of business.

Although small-company earnings tend to be more volatile then their larger cousins, their stocks outperform large-company stocks. For that reason, TSP investors should invest in small and large companies.

This poses a problem for federal employees, however. They will not be able to invest in small-company stocks until the TSP launches its new system in October. The system will enable federal employees to invest in a small-cap stock fund and an international stock fund. In the meantime, feds are losing money waiting for the new system.

The Thrift Savings Board could have — and should have — worked out an arrangement to let feds invest some TSP dollars in small-company funds while the board redesigned the system. But you are paying the price for the board wanting to make changes its own way. Asking feds to wait this long does irreparable harm to their retirement fund balances.

In the interim, consider investing in small-company mutual funds either through an IRA, if you have one, or through individual accounts. Of course, because workers who are in the Federal Employees Retirement System receive matching government contributions, it's best to make the maximum contribution to TSP that the government will match. However, once you have passed the government match ceiling, investing in a small-company fund through a tax-deductible IRA ensures that your retirement dollars will be diversified and earn respectable returns.

If your income exceeds the tax-deductible ceiling, you're probably better off investing as much as you can in the TSP, even if that means you can't invest in a small-company fund right now. That's because whatever you invest in the TSP is tax-deductible.

It's a shame however, that federal employees are forced to choose such options when the Thrift Savings Board has the ability to offer small-company funds to feds today.

If you want the names of some small-cap funds that I like, send me an e-mail.

— Zall is a free-lance writer based in Silver Spring, Md., who specializes in taxes, investing and business issues. He is a certified internal auditor and a registered investment adviser. He can be reached via e-mail at miltzall@starpower.net.

To read more from Milt Zall (Bureaucratus), type "Zall" in the search box at www.fcw.com.