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.
- Large-cap: Market value of $10 billion or more; generally
mature, well-known companies within established industries.
- Midcap: Market value between $3 billion and $10 billion;
typically established companies within industries experiencing or
expected to experience rapid growth.
- Small-cap: Market value of $3 billion or less; tend to be young
companies that serve niche markets or emerging industries.
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.
