Some investors may hold a “go big or go home” mentality when it comes to investing in companies: The biggest companies like Apple and Meta (previously Facebook) can be more stable and are oftentimes highly-prized by investors for their high market capitalization of $10 billion or more.
But small companies don't have to be a turnoff. While small-cap stocks tend to be more risky and volatile, some can be treasures for investors, especially when the companies are experiencing periods of rapid growth.
What is a small-cap stock?
A small-cap stock is a publicly traded company with a market capitalization, or value on the open market, of $2 billion or less.
Small-cap stocks are sometimes newer, least developed companies while mid-cap stocks tend to be more established. Mid-cap companies are typically companies experiencing—or have recently experienced—rapid growth, with a market value up to $10 billion.
While considered riskier compared to mid- or large-cap stocks, they can have more earnings potential compared to large-cap companies over the long-term.
Investing in small-cap vs. larger-cap companies
For investors looking to diversify portfolios, it might be helpful to explore and understand the differences between small-cap and larger-cap companies.
Small-cap stocks vs. mid-cap stocks
Small-cap stocks are somewhat like the youngest sibling: They tend to be all over the place and may need help working on consistency. Mid-cap stocks are the ones that have gotten past the rocky start of small cap and tend to be more stable investments than their small-cap siblings.
Unlike small-caps, mid-cap companies typically operate in a larger market, including internationally. Both can experience growth through mergers and acquisitions, but mid-cap companies are oftentimes on the receiving end of this activity because of their middle ground between small- and large-cap stocks. That can create growth potential with less risk.
Small-cap stocks vs. large-cap stocks
While small-cap stocks tend to be the new kid on the block, large-cap stocks are some of the most well- or long-established companies in the market. They are typically mature, well-known companies, and might be household names. They have track records with years of data to showcase performance history.
Large-cap companies are usually either major players in their respective industries or dominant in their space, and they can operate on a global scale. They might offer dividend payouts to shareholders at regular times throughout the year as an incentive to buy their stock. Large-cap companies may be more inclined to acquire other companies—possibly mid- or small-cap companies—to expand their own business or eliminate competition.
Large-cap companies can be more conservative investments. These companies might experience volatility, but not as much or as drastic as their small-cap counterparts.
What are the potential benefits and risks of small-cap stocks?
Like any investment, small-cap stocks have potential benefits and risks. It’s important to weigh both sides when considering what to include in a portfolio.
Potential benefits of small-cap stocks
- Higher growth potential. Sometimes a lower market capitalization means there’s more room for growth, and in turn, greater potential for higher earnings over the long term. The returns on small-cap stocks on the S&P 600 and Russell 2000 can outperform the S&P 500, at times, especially following a recession or bear market. According to The Wall Street Journal, the Russell 2000 gained 8% in the period between its low close on May 11 and June 1, 2022, while the S&P 500 added only 4.2%.
- Early investing opportunities. Investors can get early access to up-and-coming companies. Companies like Amazon and Microsoft were once small-cap companies that investors took a chance on. In the case of Amazon, for example, The Wall Street Journal reported that had any investor bought shares in the fledgling company in 1997 when it went public (and its market capitalization was under $2 billion), would have reaped significant returns—a $10,000 investment would be worth $4.9 million 20 years later.
Risks of small-cap stocks
- Greater volatility. Investors could be putting their money into the next big thing—or, a company that’s on the verge of flopping. Since these companies can be newly established, they may not have necessarily earned a track record so investors could measure performance of a company’s management, operational status, or finances—all which can have an impact on how a stock performs.
- More illiquid. Small-cap stocks don’t trade as frequently as their counterparts on the S&P 500. It can be harder to sell small-cap stocks for cash, so investors may sell at a big loss.
Considerations before buying small-cap stocks
If investors are considering buying small-cap stocks, they may first want to weigh whether their investment goals line up with the potential returns on small-cap stocks.
- Where do they sit within the small-cap market? The S&P SmallCap 600 is the index that follows small-cap companies to measure their liquidity and financial stability. The Russell 2000, on the other hand, measures 2000 of the smallest small-cap stocks. Investors can use these indexes as guides for assessing small-cap stocks.
- What does the data say? Since some small-cap stocks tend to have less information available, investors may need to devote more time to researching them through avenues like company websites, industry publications, or SEC reports and filings, for example. Also consider checking which small-cap companies have been around for awhile and have proven growth records during times of economic uncertainty.
- How do they fit into an overall portfolio? Individually hand-picking stocks can be a risky endeavor compared to other types of investments like mutual funds and exchange-traded funds (ETFs). Investors have different goals and priorities, and adding small-caps can diversify those portfolios. Investors can buy small-cap stocks individually or through a group of mutual funds to balance out portfolios. Risk tolerance might also impact the types of small-cap stocks investors buy.
The bottom line
Small-cap stocks can offer an opportunity for investors to get on board with a company early and potentially gain higher returns over time compared to large-cap stocks. Some investors, however, may not have the financial cushion or tolerance to invest in small-caps since these companies can be unestablished or come from developing sectors, with typically higher risk and more volatility, which can introduce to investors more potential for losses. Therefore, investors may want to consider doing their homework on small-cap stocks to make informed decisions based on their goals and risk tolerance.