Small-Cap Stocks
Small-cap stocks have been a popular investment option for investors looking to improve their portfolios. Small-cap stocks, sometimes referred to as micro-cap stocks or penny stocks, are companies with a market capitalization of less than $2 billion. These companies are typically young, small and unprofitable. Small-cap stocks represent an attractive option for investors due to their potential for high returns and diversification benefits. Investors must understand the risks and rewards of small-cap stocks in order to make an informed decision about investing in this asset class.
What Is Market Capitalization and Why Does It Matter?
Market capitalization, also known as “market cap”, is the total market value of a company’s outstanding shares. This is calculated by multiplying the company’s share price by the total number of its outstanding shares. Companies with a higher market cap are more likely to have more stable prices, more liquidity, and more analyst coverage.
Small-Cap Stocks Compared to Large-Cap Stocks
Small-cap stocks tend to be riskier investments than large-cap stocks. Large-cap companies, which typically have market capitalizations of more than $10 billion, are often more established with greater resources, and thus higher liquidity. These companies typically also have more established products and services with more robust competitive advantages, which means that their share prices are more protected from dramatic swings than those of small-cap stocks, which could be more volatile.
Another key difference between small-cap stocks and large-cap stocks is the potential for higher returns. Because small-cap companies are younger and less established, they have greater potential for growth in their formative years and therefore they may have greater chances of achieving higher returns.
The Risks of Small-Cap Stocks
There are a number of risks associated with investing in small-cap stocks, many of which are due to the smaller size of the companies. Some of the risks associated with small-cap stocks include:
Less liquidity – Small-cap stocks are less liquid than their larger counterparts due to their smaller size, which means they may be harder to buy and sell.
More difficult to research – Smaller companies may be less likely to have research coverage, and thus it could be more difficult to research them.
Potential for higher volatility – Since small-cap stocks are typically riskier than large-cap stocks, they may experience greater volatility.
Higher risks of fraud – Since small-cap stocks are more difficult to research, it makes it easier for companies to commit fraud.
The Rewards of Small-Cap Stocks
In spite of the risks associated with small-cap stocks, these investments also concede a number of potential rewards, including:
Potential for higher returns – Given their potential for faster growth, small-cap stocks may offer higher potential returns than large-cap stocks.
Diversification benefits – Investing in small-cap stocks can diversify a portfolio and reduce overall risk.
More attractive valuations – Small-cap stocks may be undervalued making them attractive investments.
Tax advantages – Small-cap stocks may also offer tax advantages due to their lower market capitalization.
Tips for Investing in Small-Cap Stocks
When investing in small-cap stocks, investors should be sure to do their research and exercise caution. Even though they may have higher returns than large caps, they could also have bigger losses. Here are some tips for investing in small-cap stocks:
Diversify – It is important to diversify investments and not put all of your eggs in one basket. Focus on a few smaller companies with unique business models that are different from each other.
Do your research – Do your due diligence and thoroughly research small-cap companies. Make sure to pay attention to management and financials to ensure that the company is sound.
Be mindful of fees – Since small-cap stocks may be more volatile and difficult to buy or sell, trading fees may be higher. Pay attention to the fees associated with trading small-cap stocks.
Be an active investor – Small-cap stocks may be more volatile so it is important to be an active investor by regularly monitoring your investments.
Small-cap stocks can be a great way to diversify and potentially increase returns. While these investments can offer great rewards, they also come with a greater degree of risk. Investors must understand the risks and rewards associated with small-cap stocks and do their due diligence before investing. By researching and carefully managing their portfolios, investors can better position themselves for success when investing in small-cap stocks.
