Company Size -- Why Market Capitalization Matters
Stocks represent ownership in companies of various sizes. Understanding the relationship between company size, return potential, and risk is crucial if you're creating a long-term strategy. With this knowledge you'll be better prepared to build a balanced stock portfolio that comprises a mix of market caps.
Sizing Up Stocks
Typically, companies are categorized in one of three broad groups based on their size -- large-cap, midcap, and small-cap. Cap is short for market capitalization, which is the value of a company on the open market.
Market cap definitions can vary, so the following are general guidelines.
To calculate a company's market capitalization, multiply its stock's current price by the total number of outstanding shares. For example, if a company issues one million shares of stock trading for $50 each, its market capitalization would be $50 million ($50 times 1,000,000 shares).
Evaluating Risk and Reward Potential
Generally, market capitalization corresponds to a company's stage in its business development. Typically, investments in large-cap stocks are considered more conservative than investments in small-cap or midcap stocks, potentially posing less risk in exchange for less aggressive growth potential. In turn, midcap stocks generally fall between large caps and small caps on the risk/return spectrum.
Why? Midcap companies may be in the process of increasing market share and improving overall competitiveness. This stage of growth is likely to determine whether a company eventually lives up to its full potential. Therefore, midcaps may offer more growth potential than large caps, and possibly less risk than small caps.
The relatively limited resources of small-cap companies can potentially make their stocks more susceptible to a business or economic downturn. They may also be vulnerable to the intense competition and uncertainties of untried markets. On the other hand, small-cap stocks may offer significant growth potential to long-term investors who can tolerate volatile stock price swings in the short term.
A standard method of gauging the performance of an investment is to measure its returns against those of an index representing similar investments. As with stocks, indexes come in all sizes and shapes. As their names suggest, the S&P Midcap 400 and S&P SmallCap 600 indexes represent midcap and small-cap stocks, respectively. The Russell 2000 is another prominent index for small-cap stocks.
Selecting the Right Combination
So what does a company's size have to do with your investment strategy? Quite a bit. Over time, large-cap, midcap, and small-cap stocks took turns leading the market as each can be affected differently by market or economic developments. That's why many investors diversify, maintaining a mix of market caps in their portfolios. When large caps are declining in value, small caps and midcaps may be on the way up and could potentially help compensate for any losses.
To build a portfolio with a proper mix of small-cap, midcap, and large-cap stocks, you'll need to evaluate your financial goals, risk tolerance, and time horizon. A diversified portfolio that contains a variety of market caps may help reduce investment risk in any one area and support the pursuit of your long-term financial goals.
Keep in mind, diversification does not eliminate risk or the risk of potential loss.
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