Small Cap Stocks: What They Are and How They Can Help Diversify Your Portfolio

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Small companies can present big opportunities for investors — but for every small company that turns into Amazon, scores more fail in the first year. 

For a typical retirement-minded investor, small cap stocks present an opportunity to benefit from the upside while downplaying the risk of these smaller companies and the small cap stocks investors can buy — all within a broader investment portfolio.

A small cap stock is a company with a market capitalization of less than $2 billion. The market cap refers to the total value of a given company’s total shares of stock. When combined with other investment strategies, small cap stocks can help diversify your portfolio. 

Here’s what the experts have to say about small cap stocks and how they might factor into your retirement strategy.

What Is a Small Cap Stock?

Small cap stocks are calculated by a company’s market capitalization or valuation. A market cap is found by multiplying the price of a stock by the number of shares out in the market. The definition of a small cap stock varies from broker to broker but it’s typically a company that is valued from $300 million to $2 billion. 

Small cap stocks are usually associated with companies that are relatively young. For companies that continue to grow and succeed, the upside to buying stock early is clear. But of course with that upside comes significant risk: There’s no guarantee that a young company will survive, and even good early performance may not last long-term.

Pro Tip

Small cap stocks can be a highly rewarding piece of your investment portfolio. But before you jump in, do your research and consider buying a small cap index fund.

On the other hand, there are large cap stocks. Large cap stocks have a market capitalization of $10 billion and up. Mid cap stocks are in the middle with market caps of $2 billion to $10 billion. Large cap stocks represent a majority of the total U.S. stock market. Large cap stocks are companies like Apple, Amazon, Facebook, Walmart and Mastercard, just to name a few. 

While larger companies may have less room for big growth in value, they come with a track record that tends to indicate a more enduring value. For investors, a mix of small, mid, and large cap stocks offers a way to benefit from what they all have to offer — while minimizing the risks that come with a portfolio that lacks diversity.

How To Invest In Small Cap Stock

While it’s possible to invest in small cap stocks by buying shares in individual companies, a much better way for most investors is to add them to your portfolio through an index fund. 

An index fund is an investment vehicle that lets investors buy shares in large slices of the the stock market. A popular small cap index fund is the Russell 2000 index. It consists of 2,000 small cap companies across a wide variety of industries. In the last 10 years, the Russell 2000 index returned an average annual return index of 12%. Another popular index is the S&P SmallCap 600 index, which returned 11% over the last 10 years. Investing in an index fund reduces your risk of your investments being tied to one company or index in case that section of your portfolio takes a downturn. 

Small cap stocks can also be included in broader target date or total market index funds, combining shares in smaller companies with shares in larger companies.

You can buy index funds through a taxable brokerage account or through tax-advantaged retirement accounts like a 401(k) or a Traditional or Roth IRA. Index funds have low expense ratios or fees — one of the big reasons they are so popular among experts and investors alike. Experts love index funds because they’re easy to manage but be sure to keep an eye on your investments as they’re growing. Experts like to diversify their portfolios with a mix of large cap stocks, mid cap stocks and small cap stocks. 

“By buying into a diversified fund, you gain exposure to the upside without having to choose the specific companies, which involves a lot of research and a lot of risk to your capital,” said Ron Guay, a certified financial planner with Rivermark Wealth Management.

Large Cap vs. Small Cap Stocks

A balanced portfolio benefits from the unique upsides of both small and large cap stocks, while at the same time diminishing the risks and downsides that might come from investing in all of one or the other. 

Here are some of the most general differences between the companies behind small and large cap stocks:

Large cap stocksSmall cap stocks
Market value usually above $10 billionMarket value of less than $2 billion
Larger, more established companiesSmaller companies
Slow and stable growthFast, high growth potential
Tend to pay consistent dividendsGreater likelihood of failure than more established companies

What Are the Risks of Investing in Small Cap Stocks?

Any type of investing involves risk, but putting money only into small cap stocks can expose you to the potentially high failure rate of young, growing companies. By diversifying your investments, you protect yourself from your portfolio being invested in one section. 

A small cap index fund lets you invest in a group of smaller companies and avoid the risk of investing in any one company. For example, if you invested $1,000 in a single small company only to see that company fail a year later, chances are you’d be out your $1,000. But $1,000 invested in a small cap index fund spreads it out across many companies, diminishing your losses in the event of one company failing.

More broadly, an investment portfolio featuring a mix of large and small cap stocks, as well as much safer bonds, diminishes your risk even further

Should You Invest in Small Cap Stocks?

Small cap stocks can — and should — be a part of any investor’s diversified portfolio.

But again, the devil is in the details. Individually picking small cap stocks can be very risky, whereas buying into a small cap index fund is a safer bet. And to truly see the benefits of the volatile small cap market, you need to hang on to your holdings for the long term.