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.

RELATED FAQS
  1. Is the average return on small cap companies better than large cap companies?

    Learn the difference between small-cap and large-cap companies, and find out which type of company is likely to yield a higher ... Read Answer >>
  2. Does investing in small cap stocks have advantages over investing in big cap stocks?

    Learn about the advantages of investing in small-cap stocks, and find out why some investors buy shares in small-cap rather ... Read Answer >>
  3. What is the difference between a penny stock and a small cap stock?

    Learn about penny stocks and small-cap stocks, how stocks are classified as these types, and the difference between penny ... Read Answer >>
  4. Are small cap companies less safe investments than large cap companies?

    Compare the safety of investing in small- and large-cap companies. Find out how each performs in different situations and ... Read Answer >>
  5. What is the difference between market capitalization and shares outstanding?

    Understand the relationship between shares outstanding and market capitalization and how market cap is interpreted to establish ... Read Answer >>
  6. What should I use as a benchmark for my small-cap stock portfolio?

    When creating a stock portfolio, it is important to have a benchmark against which you can compare your returns. Comparing ... Read Answer >>
Related Articles
  1. Financial Advisor

    How to Make Small-Caps Win for Your Portfolio

    Small-cap stocks can offer generous returns, but you need to know how to find the right ones. Here's a little help.
  2. Investing

    Why Small-Caps May Be a Good Bet if Rates Rise

    While small-cap stocks may suffer if rates rise, they may also turn out to be winning performers in this environment.
  3. Investing

    IJS: iShares S&P Small-Cap 600 Value ETF

    Learn how the iShares S&P Small-Cap 600 Value exchange-traded fund is managed, which benchmark it tracks and for whom it is most appropriate.
  4. Investing

    How to Ride the Small-Cap Rally (IWM,SCHA)

    Small-caps are on a bullish tear. Here's how to play the rally.
  5. Investing

    ETF Analysis: WisdomTree SmallCap Earnings

    Discover the WisdomTree Small Cap Earnings ETF, a fund with a special focus on small-cap and micro-cap stocks with positive earnings.
  6. Financial Advisor

    Playing Small-Caps In This Market? The Key Is Dividends

    Small-cap stocks have taken a beating at the hands of jittery investors, but there are opportunities if you focus on dividends.
  7. Investing

    Is it Wise to Diversify with Small-Caps?

    Historically, it's always been a good idea to add small-caps to your portfolio. But doing so right now will require more focus and attention.
  8. Investing

    Playing Penny Stock-Like ETFs

    While there are no penny stock ETFs or mutual funds, a shrewd investor can pick from a number of small-cap and micro-cap equity ETFs for a similar effect.
  9. Investing

    Valuing Small-Cap Stocks

    When done right, small-cap investing can improve the performance of your portfolio without adding a great degree of risk.
  10. Investing

    The 4 Largest Small-Cap ETFs (IWM, IJR)

    Learn about how U.S. small-cap stocks have performed in 2016 and over the past year, and the top four largest U.S. small-cap ETFs by assets under management.
RELATED TERMS
  1. Small Cap

    Refers to stocks with a relatively small market capitalization. ...
  2. Nasdaq SmallCap Market

    The Nasdaq equity market for companies that have relatively small ...
  3. Market Capitalization

    The total dollar market value of all of a company's outstanding ...
  4. Large Cap - Big Cap

    A term used by the investment community to refer to companies ...
  5. Fama And French Three Factor Model

    A factor model that expands on the capital asset pricing model ...
  6. Dow Jones Wilshire Small-Cap Index

    Former name of the Wilshire US Small-Cap Index, a market-capitalization ...
Hot Definitions
  1. Five Cs Of Credit

    A method used by lenders to determine the credit worthiness of potential borrowers. The system weighs five characteristics ...
  2. Straddle

    An options strategy in which the investor holds a position in both a call and put with the same strike price and expiration ...
  3. Trickle-Down Theory

    An economic idea which states that decreasing marginal and capital gains tax rates - especially for corporations, investors ...
  4. North American Free Trade Agreement - NAFTA

    A regulation implemented on Jan. 1, 1994, that eventually eliminated tariffs to encourage economic activity between the United ...
  5. Agency Theory

    A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving ...
  6. Treasury Bill - T-Bill

    A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations ...
Trading Center