Investing Basics: Small-Cap Stocks

Small-cap stocks are shares of companies with a total market capitalization in the range of about $300 million to $2 billion. Small-cap companies have the potential for high growth rates, making them attractive investments, though their stocks may experience more volatility and pose higher risks to investors.

Why Is Market Capitalization Important?

Market capitalization measures a publicly traded company’s total market value. You can calculate market cap by multiplying a company’s current stock price by the total number of shares outstanding. Market cap data is generally available for publicly traded companies on any website that provides real-time stock information.

Market cap is generally used to divide stocks into three categories based on size: large-, mid-and small-caps. A company’s size in market capitalization doesn’t tell its whole story, but market cap information is helpful for various vital decisions.

Market capitalization data is helpful for investors when they are evaluating the growth and risk prospects of stocks to include in their portfolios. Grouping companies of similar sizes allows you to compare their stocks and performance better.

Index providers also use the market cap to determine which companies should be included in benchmarks. These composition decisions directly impact which stocks are included in any index funds you own.

Actively managed funds rely on market cap designations as well. Fund managers may craft an investment strategy to focus on particular segments of stocks based on their market cap. And in the business world, companies could look for possible acquisition opportunities within small-cap competitors.

What Are Small-Cap Stocks?

Small-cap stocks are the most numerous companies in the market. There are more small-cap stocks than large- and mid-cap stocks combined. That’s thanks to the broad range of market capitalizations included in the small-cap stock designation: Anything from about $300 million to $2 billion can be considered a small-cap stock.

Because of their size, small-cap stocks have different risks and rewards for investors than their larger counterparts. Small-caps include the next hot company everyone will be talking about, along with companies on the brink of bankruptcy and ones that are prime targets for acquisition.

As a result, small-cap stocks can experience larger-than-average volatility, which is another way to refer to rapid gains and losses. Over long periods, investors may be rewarded if they stomach the ups and downs along the way. However, in the short term, some small-cap stocks may experience wild swings and be illiquid, meaning they don’t trade as frequently and can be difficult to sell for cash.

In the past 20 years, the S&P SmallCap 600 index, a leading benchmark for small-cap stocks, has outperformed its related indexes for large- and mid-caps on an average annualized basis, according to figures from S&P Dow Jones Indices. During that period, the S&P’s benchmark small-cap index returned an average of 8.3% annually, compared to 8% and 6.3% from its mid- and large-cap counterparts.

The following indexes are often used as benchmarks for the U.S. small-cap universe. Both include companies in a variety of industries:

• Russell 2000 Index. The Russell 2000 Index includes approximately 2,000 of the smallest U.S. stocks. Companies had a median market cap of $1.2 billion as of September 2021.
• S&P SmallCap 600 Index. The S&P SmallCap 600 Index tracks the performance of 600 small-cap companies, with a median market cap of approximately $1.4 billion as of September 2021.

Small-Cap vs. Mid-Cap Stocks

Mid-cap stocks are those whose market caps range from $2 to $10 billion. Beyond size, there are other essential differences between small- and mid-cap stocks:

1. Stage in the business lifecycle. Companies in the mid-cap space occupy a sweet spot: They may be more established in their respective industry with a more robust lineup of products or services than small-caps, but they aren’t yet the big household names everyone knows.
2. Geography. Both small- and mid-cap companies derive a majority of sales within their domestic economy. However, companies in the mid-cap space are more likely to begin operating outside their home country.
3. Growth. Both mid and small-cap companies have significant growth potential, depending on their industry. Mid-caps are more likely than small-caps to be involved in a merger or acquisition, which can propel their growth prospects.
4. Risk. As a group, mid-caps are considered less risky than small-caps because of their more established business models.
5. Volatility. Because of their lower relative risk, mid-cap stocks also are less volatile as a group than small-caps.

The two primary benchmarks for mid-cap stocks are:

• S&P MidCap 400 Index. This benchmark tracks the performance of 400 mid-sized U.S. companies with a median market cap of nearly $5.5 billion as of September 2021.
• Russell Midcap Index. This index tracks a larger universe of approximately 800 mid-cap companies with a median market cap of around $11 billion as of September 2021.

Small-Cap vs. Large-Cap Stocks

There are even more significant differences between small- and large-cap stocks. Small-caps are a fraction of the size of large-caps (with market caps over $10 billion), but the business and investment prospects are also quite different.

1. Stage in the business lifecycle. Large-cap companies are well established in their industry, with a broad and diversified business that includes various products and services. These companies may even dabble in different industries.
2. Geography. Large-cap companies operate globally, and only 62% of their sales come from the U.S., compared with 79% for small-cap companies, according to 2019 compiled by S&P Dow Jones Indices. If there’s a slowdown in the U.S., small-cap stocks are more likely to take a hit.
3. Growth. By the time companies become large-caps, the most significant gains in their history may already be over. By this point, however, they are more likely to acquire other companies to expand their businesses, including those in the small-cap space.
4. Risk. Because their businesses are more established, with a diverse lineup of companies operating in multiple countries, investing in large-cap stocks is less risky than small-caps that don’t share those same attributes.
5. Volatility. While any individual stock price can jump around a lot, large-cap stocks are less likely than small-caps to experience wild swings.

There are other gauges for tracking the U.S. large-cap market, but far and away, the most commonly cited one is:

• S&P 500 Index. The S&P 500 tracks the performance of the 500 largest publicly traded companies in the U.S. As of September 2021, these companies had a median market cap of $21 billion.

Small-Cap Stocks and Asset Allocation

Even though small-cap stocks can be riskier, investors may still choose to invest in them to benefit from the higher potential gains. What’s more, these companies aren’t so affected by slowdowns in other regions of the world because most of their sales come from the U.S., so investing in small-cap stocks is a way to benefit from a strong U.S. economy.

The amount of money you allocate to small-caps versus mid- or large-caps ultimately comes down to your risk tolerance and investment goals.

According to recommended models from the American Association of Individual Investors, a conservative investment strategy might have a 10% allocation to small-cap stocks, compared with 20% for an aggressive approach. While you may choose a different allocation than these guidelines, ensure you understand the potential tradeoffs.

Ways to Invest in Small-Cap Stocks

You can invest in small-cap company stocks by purchasing shares through your preferred brokerage or investment account. Keep in mind that there is less information available about small-cap companies (analyst research) than their larger counterparts. These companies also face more significant business uncertainty. As a result, researching which small-cap stocks you want to buy can be time-consuming, and introducing small-cap stocks can add unforeseen risks to your portfolio.

Instead, many investors choose to invest in small-cap companies by buying mutual funds or exchange-traded funds (ETFs) that track the broad small-cap indexes, specific industries, or characteristics like growth versus value.

Vanguard manages seven mutual funds and ETFs Gold-rated by Morningstar as of mid-2020. These include funds focusing on value, growth, and a blended strategy. The Morningstar picks include:

• Vanguard Small Cap Index (VSMAX)
• Wasatch Small Cap Growth (WAAEX)
• Boston Partners Small Cap Value (BPSIX)

There are more than 60 ETFs that precisely track U.S. small-cap stocks, according to ETFdb.com. The three most significant funds by assets are:

• Vanguard Small Cap Value ETF (VBR)
• Vanguard Small Cap Growth ETF (VBK)
• Schwab U.S. Small Cap ETF (SCHA)

As with any investment, it’s essential to do your research before selecting any individual stocks or funds for your portfolio. Consider meeting with a financial advisor to discuss any new additions to your investment strategy.