This is one of the major risks associated with small-cap investing: small-caps can face more volatility than larger stocks, especially during economic downturns.
Small-caps tend to underperform large-caps in times of economic woe as they are perceived as riskier assets and more vulnerable to market shocks.
During the March 2020 crash precipitated by COVID-19, for example, the ASX Small Ordinaries Index fell more than the ASX 200. But as the market began to recover, the Small Ordinaries outperformed the ASX 200, neatly showcasing the risk-reward inherent in the small-cap sector.
That said, the small-cap universe is vast. Small-caps don’t move in unison. At the end of the day, small-cap stocks are individual businesses and should be appraised on that basis first and foremost.
It is also important to note that the stock market is not the economy. Moves in the wider economy do not have to perfectly correlate with moves in the markets, including the small-caps sector. While the stock market and the economy are not entirely disconnected, the two diverge much of the time.