26 Dec 2022
Growth in a small-cap company could reap lucrative returns for investors who spot it early as “the next big thing.” But does a small cap’s risk outweigh its potential reward? Here are ways to answer this question.
What is Small Cap Investing?
Growth in a small-cap company could reap lucrative returns for investors who spot it early as “the next big thing.” Or a small-cap company could stall or go bankrupt, especially in uncertain economic times. Does a small cap’s risk outweigh its potential reward? That’s a question for each individual investor to answer as they weigh the pros and cons of investing in small cap stocks or in mutual funds or ETFs that feature small caps.
Small-capitalization stocks, also called small caps, are companies whose relatively small market capitalization values are packed with potentially big growth for investors. A company’s market cap value is calculated by multiplying the number of outstanding shares by the price of available shares. Small caps are in the range of $250 million to $2 billion in market capitalization. You can even use Magnifi’s search tools to find companies with specific market capitalizations.
The key to why small-caps are so attractive to investors seeking growth is that historically, small caps have outperformed large caps. As of late 2021, over the past 20 years, the S&P 600, an index of small cap-stocks, had outperformed its related indexes for large- and mid-caps on an average annualized basis, according to figures from S&P Dow Jones Indices (2).
But a company’s market capitalization is more than a number—it’s how people perceive a company’s growth, its risk, and its potential. It’s important to note that any hype surrounding the company or bad press can also influence that value.
The result of that calculation puts the company into one of three major baskets: large-cap, mid-cap, or small-cap companies. Small-cap companies can become mid-cap or large-cap, such as when once upon a time, large-cap stock giants like Apple and Microsoft had been risky small-caps.
The small-cap universe runs the gamut from the next hot company everyone is talking about to companies teetering on the brink of bankruptcy. Technically, a small-capitalization stock is defined as one whose valuation lies in the range of $250 million to $2 billion, which seems large but isn’t in comparison to the billions or trillions of market share in the largest companies, like Alphabet. The most popular gauge in the small-cap segment is the Russell 2000 index. This benchmark is composed of the 2,000 smallest companies in the Russell 3000. The typical index stock has a median market cap of roughly $1.15 billion (3).
There are downsides. As the market slowly came back to life between 2020 and 2021, the S&P 600 gained three times the return of large caps. However, with economic headwinds pushing hard in 2022—and due to the vulnerability of small caps to supply chain issues and high inflation—small-cap stocks haven’t repeated those gains (4). Despite these risks, investors see many of these smaller companies having tremendous upside potential. Investors will continue to look for the “next Amazon” that will deliver returns of 100 times or more.
Volatility. Small caps may experience more volatility. Since many small-cap stocks have little to no earnings, or limited cash on their balance sheets, more of them file for bankruptcy than their larger peers. This is especially a risk during tough times economic times because their balance sheets aren’t as strong as larger companies’, and they don’t have the same access to lending.
A domestic focus. Many of these smaller companies are domestically focused, and so investors who put their money in might miss growth opportunities overseas.
Locked-in cash. Small caps do not pay a dividend, which some investors rely on to supplement income. In the shorter term, some small-cap stocks may experience wild swings in price and can be illiquid, meaning they don’t trade frequently and can be difficult to sell for cash.
Investing in individual small-cap stocks can let investors tap into potential growth that is unmatched by larger companies. There’s even a place at the small-cap table for the “set it and forget it” passive investors: small-cap index funds offer another way to boost returns. However, small-cap opportunities for big profits come with some risks, a sacrifice of stability for potential.
So how do you know if small-cap investing is right for you? Here are 3 questions to ask yourself when deciding how to invest in small caps:
How will investing in small caps impact my portfolio?
The answer depends on the risk potential of all of your entire investments, taken as whole. If you have half of your portfolio in Treasury bonds, which are more stable, putting a small percentage in risky small-cap stocks would make sense and give your portfolio some growth potential. (You can ask your financial advisor about the level of risk in your portfolio, and if you’re investing on Magnifi, you can ask your virtual investing assistant.)
Will investing in small caps boost—or derail—my financial plans?
If you’re a younger investor who plans to hold stocks for decades, you might be generally better suited for small-cap investing. If you’re a retiree living off dividend income, investing in small caps might be too risky.
Does investing in small caps match my risk tolerance?
Your own individual risk tolerance will determine how much money you put into small-cap stocks. If you have some safer large caps, bonds, and funds, you may consider putting a percentage of your money at higher risk to try to get higher returns.
Ultimately, owning a few small-cap stocks can be a good idea for most investors. If just one of these stocks takes off, it can transform your wealth or make up for dozens of bad picks.
Investing in a single small-cap company can open you up to risk, but there are many mutual funds and ETFs that focus on small-cap companies to choose from. It’s wise to research the past performance of small-cap stocks or funds before you decide to invest, which takes a lot of time that you might not have. On Magnifi, you don’t need to spend hours doing research to find the right small-cap stock or ETF for you. Find small caps with a search:
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This material is provided for informational purposes only and should not be construed as individualized investment advice or an offer or solicitation to buy or sell securities tailored to your needs. Investors should carefully consider the investment objectives and risks as well as charges and expenses of all innovation-related securities before investing. Read the prospectus carefully before investing. ETFs and mutual funds are actively managed and there is no guarantee that the manager’s investment decisions will produce the desired results. All investments involve risks, including possible loss of principal. ETFs trade like stocks, fluctuate in market value and may trade at prices above or below their net asset value. Brokerage commissions and fund expenses will reduce returns. You should carefully consider a fund’s investment goals, risks, charges and expenses before investing. Download a summary prospectus and/or prospectus, which contains this and other information and read it before you invest or send money.