Key Points
Stocks represent ownership in companies of various sizes. Some may
be corporate giants with household names like Microsoft and General
Electric. Others may be industry newcomers with revenue and
resources a fraction the size of their larger brethren, but with
the potential for rapid growth, as well as greater risk.
Understanding the relationship between company size, return
potential, and risk is crucial if you're creating an investment
strategy designed to help you pursue long-term financial goals.
With that 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. 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).
Definitions of the different market-cap categories may differ --
from one mutual fund company to another, for instance -- but here
are some examples:
- Large-cap company -- market value of $10 billion or more.
- Midcap company -- market value between $3 billion and $10
billion.
- Small-cap company -- market value of $3 billion or less.
Corporations with valuations of less than $1 billion are sometimes
referred to as microcap companies. Of course, companies often grow
and shrink in size with the passage of time. Microsoft, today one
of the world's largest companies, was once run on a shoestring. And
given the changing nature of the marketplace, who knows what
tomorrow may bring?
Evaluating Risk and Reward Potential
Generally, market capitalization corresponds to where a company
may be in its business development. So a stock's market cap may
have a direct bearing on its risk/reward potential for investors
looking to build a diversified portfolio of investments.
Large-cap stocks are generally issued by mature, well-known
companies with long track records of performance. Large-cap stocks
known as "blue chips" often have a reputation for producing quality
goods and services, and a history of consistent dividend payments
and steady growth. Large-cap companies are often dominant players
within established industries, and their brand names may be
familiar to a national consumer audience. As a result, investments
in large-cap stocks may be considered more conservative than
investments in small-cap or midcap stocks, potentially posing less
risk in exchange for less aggressive growth potential.
| Who'll Lead
the Pack Next? |
In recent years, small-cap indexes have outperformed large-cap
indexes, although historically, they have taken turns leading the
market. This chart ranks them in order of performance, from first
place to third. Given the results, it may make sense to establish a
diversified portfolio of investments representing different market
capitalizations.
|
|
S&P 500 |
S&P MidCap 400 |
S&P SmallCap 600 |
| 2003 |
3 |
2 |
1 |
| 2004 |
3 |
1 |
2 |
| 2005 |
3 |
1 |
2 |
| 2006 |
1 |
3 |
2 |
| 2007 |
2 |
1 |
3 |
| 2008 |
3 |
2 |
1 |
| 2009 |
2 |
1 |
3 |
| 2010 |
3 |
2 |
1 |
| 2011 |
3 |
2 |
1 |
| 2012 |
3 |
2 |
1 |
|
| Source: Standard & Poor's. Based on average annual total
returns for the 10-year period ended December 31, 2012. Large-cap
stocks are represented by the S&P 500; midcap stocks by the
S&P Midcap 400 Index; and small-cap stocks by the S&P
SmallCap 600 Index. Unmanaged indexes do not take into account the
fees and expenses associated with investing, and individuals cannot
invest directly in any index. Past performance cannot guarantee
future results. |
Midcap stocks are typically issued by established companies in
industries experiencing or expected to experience rapid growth.
These medium-sized 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. Midcap stocks generally fall between large
caps and small caps on the risk/return spectrum. Midcaps may offer
more growth potential than large caps, and possibly less risk than
small caps.
Small-cap stocks are issued by young companies that generally
serve niche markets or emerging industries, such as those in the
technology sector. Small caps are considered the most aggressive
and risky of the three categories. The relatively limited resources
of small companies can potentially make them more susceptible to a
business or economic downturn. They may also be vulnerable to the
intense competition and uncertainties characteristic of untried,
burgeoning 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.
| Measuring
Returns -- Using a Proper Index |
|
A standard method of gauging the performance of an investment is
to measure its returns against those of an index representing
similar investments. Like stocks, indexes come in all sizes and
shapes. Depending on its objective, an index may represent the
performance of a limited number or a wide range of stocks from
different sectors, industries, or geographic regions of the country
or world. Among the most recognizable "market-cap" index providers
are Standard & Poor's and Russell Investment Group.
To adequately measure how well or poorly an investment is doing,
an index must represent equities that are comparable in nature to
those under evaluation. It wouldn't be accurate to use a small-cap
index to assess the performance of large-cap stock fund or vice
versa, for example.
The Russell 2000 is a prominent index for small-cap stocks,
while the Russell 1000 represents large-cap stocks. The S&P 500
is among the best known yardsticks for large-cap stocks. As their
names suggest, the S&P MidCap 400 and S&P SmallCap 600
indexes represent midcap and small-cap stocks, respectively. One of
the oldest benchmarks, the Dow Jones Industrial Average, represents
the performance of 30 of the nation's most revered blue-chip
stocks. Although the Dow is frequently referred to by the popular
press, it represents only a tiny fraction of the stocks traded
daily in the United States.
Each group of stocks may be influenced differently by current
market conditions, underscoring the importance of diversification
and the need to compare apples to apples. Individuals cannot invest
directly in any index.
|
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 have tended to take turns leading the market (see table).
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.
Points to Remember
- Company size is often referred to as market capitalization,
which is the value of a company on the open market.
- Market cap definitions vary, but in general large-cap companies
have a cap of $10 billion or more; midcap companies have a cap
between $3 billion and $10 billion; and small-cap companies have a
cap of $3 billion or less.
- A stock's market cap may have a direct bearing on its
risk/reward potential.
- A diversified portfolio that contains a mix of market caps may
help reduce investment risk in any one area and support the pursuit
of long-term financial goals.
- It's important to use the right index when gauging the
performance of an investment in a particular market-cap
category.
