A:

Market capitalization is a key element in achieving proper diversification in an investment portfolio precisely because there are different levels of risk between large- and small-cap stocks. Although small-cap stocks are considered riskier investments than large-cap stocks, there are enough small-cap stocks offering excellent growth potential and high potential returns on equity to warrant their inclusion in the equity holdings of all but the most conservative investors.

There are four primary aspects of small-cap stocks that make them potentially riskier than large-cap stocks. One is that small-cap stocks have a lower trading liquidity. For investors, this means enough shares at the right price may be unavailable when they wish to buy, or at times, it may be difficult to sell shares quickly at favorable prices.

Another aspect is that, in comparison to large-cap companies, small-cap firms generally have less access to capital and, overall, not as many financial resources. This makes it difficult for smaller companies to obtain necessary financing to bridge gaps in cash flow, fund new market growth pursuits or undertake large capital expenditures. This problem can become more severe for small-cap companies during economic cycle lows.

A third aspect of potential added risk with small-cap stocks is simply a lack of operational history and the potential for unproven business models to prove faulty. These two factors can make it difficult for smaller companies to effectively compete with larger companies. Because small companies are not as likely to have an established, loyal customer base, they are more vulnerable to consumer preference changes.

The fourth aspect of risk with small-cap companies comes in the arena of information. Not as much information about small companies is commonly available to the public, and this makes informed evaluation of small-cap stocks more difficult for potential investors.

Despite the additional risk of small-cap stocks, there are good arguments for investing in them. One advantage is that is easier for small companies to generate proportionately large growth rates. Sales of $500,000 can be doubled a lot more easily than sales of $5 million. Also, smaller companies, often run by a small, intimate managerial staff, can more quickly adapt to changing market conditions in somewhat the same way it is easier for a small boat to change course than it is for a large ocean liner.

Another advantage in investing in small-cap stocks is the potential for discovering unknown value. The general rule of the investment world is that the majority of Wall Street research is aimed at a fraction of publicly traded companies, and most of these companies are large cap. Small-cap companies fly more under the radar, and therefore hold greater potential for finding undervalued stocks.

Lack of market liquidity can sometimes be of benefit to small-cap investors who already own shares. If large numbers of buyers suddenly seek to buy a less liquid stock, this can drive up the price further than in the case of a more liquid market. Good portfolio management includes mixing in a moderate proportion of well-chosen small-cap stocks with less volatile large-cap stocks.

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