Small cap stocks are stocks in smaller companies, typically those worth between $250 million and $2 billion. Small cap stocks often have high growth potential, which makes them a potentially attractive investment. However, while investors may see higher returns with these stocks, they may also mean higher volatility and risk levels.
If you’re considering adding small cap stocks to your portfolio, it’s essential to understand how these stocks work and the advantages and disadvantages that come with this type of investment.
What Are Small Cap Stocks?
With a market cap between $250 million and $2 billion, small cap companies are usually moderately young companies. Small cap stocks typically have some growth potential, but they may not have a longstanding history of performance. Therefore, these stocks are considered to be riskier than mid-cap or large cap stocks.
Understanding Market Capitalization
Market capitalization, or market cap, is a measure of an individual company’s value. The market cap represents the value of total outstanding shares. Investors can use this value to compare similar companies as well as consider future growth predictions.
To calculate a company’s market cap, multiply the total number of outstanding shares by the current share price. For example, let’s say a company has 15 million outstanding shares at a share price of $25 per share. Using this calculation, the company’s market cap would be $375 million.
Due to share price fluctuations, the market cap fluctuates over time. To find the number of outstanding shares, investors can review the “capital stock” numbers on a company’s balance sheet. This information is updated during the quarterly filings with the Securities and Exchange Commission (SEC).
Are Small Cap Stocks a Good Investment?
They may be a good investment, as part of a diversified portfolio, but there are risks. The market cap of a company can give investors an idea of the risk and reward of purchasing individual stocks. Purchasing small cap stocks may be riskier than buying stocks of larger companies because the companies are often still in growth mode. In addition, small cap companies have fewer resources than large-cap companies and may have less access to liquidity.
Due to these factors, any market dip can negatively impact small cap stocks. Conversely, smaller companies often have higher upside potential, and small cap growth stocks may deliver higher returns than their peers. Still, investors who choose these investments may have to weather market volatility along the way to growth.
Pros of Investing in Small Cap Stocks
There are several benefits to investing some of your portfolio into small cap stocks.
Growth Potential
When comparing large cap stocks to small cap stocks, small cap stocks tend to have a higher growth potential over the long-term. In fact, from 1926 to 2019 , small cap stocks have had an annualized return of 11.90%, while U.S. large cap stocks produced 10.14%. Government bonds annualized even less, at 5.5%.
This growth potential makes small cap stocks an attractive investment choice for investors. They tend to perform particularly well after recessions, during economic expansion.
Often Undervalued
Analysts usually spend less time analyzing small cap stocks, so they get less attention from investors which can lead to lower demand–and lower prices. Therefore, investors can leverage the inefficiencies of the market for potentially better returns.
Financial Institutions Don’t Increase Stock Prices
Specific regulations may not allow financial institutions such as hedge funds and mutual funds to heavily invest in small cap stocks. Therefore, it’s unlikely that large investments from financial institutions will artificially increase the stock price.
Cons of Investing in Small Cap Stocks
While small cap stocks have their benefits, there are also several drawbacks that investors should consider.
High Risk
Investing in small cap stocks can create higher risks for investors. Since they’re often younger companies, small cap companies do not always have a time-tested business model. If the company’s management can not make appropriate adjustments to the business model, it may yield poor financial or operational results.
Also, because small cap companies may lack the resources such as capital or access to financing that larger companies have, they may struggle to expand the business or fill in cash flow gaps, especially if the economy hits hard times.
Time-Consuming
Due to the limited availability of research and analysis done on small cap stocks, investors may have to spend a significant amount of time researching each investment option.
Minimal Liquidity
Small cap stocks tend to have less liquidity than large cap company stocks. Since there are fewer shares available, investors may not be able to purchase the stock. Conversely, investors may not be able to sell their shares at a reasonable price. The liquidity of small cap stocks adds to the risk of investing in this type of stock.
How to Invest in Small Cap Stocks
Investors can purchase small cap stocks through a brokerage firm or an individual investment account. Since there’s often less public information available about small cap stocks, investors must do their own due diligence in researching companies to understand their potential risks and returns.
Investors who don’t have the time or expertise to determine which individual small cap stocks to buy can invest in small cap companies by purchasing mutual funds or exchange-traded funds (ETFs) that track a broader range of small cap indexes. Some funds may also have unique characteristics within them, such as growth- or value-oriented stocks.
Buying mutual funds and ETFs allow investors to pool funds with other investors to sell and buy buckets of market securities. This type of investing aims to mitigate risks by diversifying investments. Instead of investing in a single company, fund investors are purchasing shares in dozens or hundreds of companies. Investing in mutual funds and ETFs is more of a passive investment strategy that doesn’t require investors to make trades actively.
Diversifying With Small Cap Stocks
Even though small cap mutual funds and ETFs provide diversification within a specific asset class, investors can further reduce their risk exposure by expanding diversification to a broader mix of assets.
Depending on market conditions, different types of stocks may perform differently. The concept can apply to stocks of companies that vary in sizes. Depending on what the market is doing, small, medium, and large companies may either beat the market returns or underperform.
When diversifying a portfolio, investors may start by determining their investment goals, risk tolerance, and time horizon. Then, by assessing these factors, they can decide an appropriate asset allocation to determine the portfolio’s percentage that may include stocks. A typical example is a portfolio composed of 60% stocks and 40% bonds.
Investors use the same factors (time horizon, goals, and risk tolerance) to decide the mix of stocks that will go into the portfolio’s stock percentage portion. Then, as market fluctuations happen, allocations of the portfolio will perform inversely.
For instance, as small cap stocks are rising, mid cap stocks may fall. In this case, small cap stock prices’ upward movement can offset the decrease in mid cap stock prices, thus mitigating losses.
The Takeaway
Although small cap stocks have the potential for long-term growth, they tend to come with more risk. With this in mind, building a diversified portfolio with a broader range of investments can help minimize your risk exposure.
But, attempting to build an entire portfolio from scratch and keep it balanced can be time-consuming and a risky venture if you’re an average investor. Instead, many investors choose to get small cap exposure by purchasing mutual funds and exchange-traded funds (ETFs), which mimic the returns of indices that track stocks meeting certain criteria.
To start, you may want to consider opening an online investing account with SoFi Invest. Your goals will determine the type of account you select. If you prefer a hands-off investment approach, you may want to consider the automated investing account. With the automated investing account, the funds you choose to invest in are already diversified across factors such as the market cap. On the other hand, if you want to invest in individual stocks, you may want to consider the active investing account.
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