Should I invest in small cap or large cap stocks?

If you’re building your investment portfolio, you will research various companies with a market cap. One common argument is that small cap stocks offer higher returns than large caps because they have more capacity to grow.  However, being smaller makes them vulnerable to economic shocks. In this article, we explore the differences between small and large caps, how both impact investment return and the implications for your portfolio strategy.  We hope you find this content helpful, and please get in touch if you’d like to discuss your financial plan with us.

The definition of small & large caps

Generally speaking, both small and large caps are publicly-traded stocks. The word “cap” refers to the “market (cap)italisation” of the stocks. Market cap is the value assigned to a company on the stock market. You can calculate this by multiplying the current share price by the total number of shares.

How are companies’ stocks valued?

At the time of writing, Amazon has a market cap of $1.82tn (share price of 3,580.41 x 507,150,000 shares is about $1.82tn). Which is an exceptionally high market cap – placing Amazon firmly in the “large cap” category.  If a company’s share price goes down, its market cap will also fall (due to the calculation above). When you hear news about a company “losing X amount from its market value”, it can mean that a stock moves from a large cap to a small cap. The critical thing to remember is that a “large cap” company does not necessarily mean that it offers higher returns. Indeed the opposite is often true.  

The difference between small-cap stocks & large-cap stocks

To keep it simple, we’ve highlighted the main differences between the two. 

Large-cap stocks:

• Companies valued above $10 billion
• Typically more stable
• Less potential for fast growth
• Pay dividends

Small-cap Stocks:

• Companies valued between roughly $250 million and $2 billion
• Usually more volatile
• Potential for significant growth in short-term
• Unlikely to pay dividends

 

Why are small caps seen as a better investment?

Various studies have indicated that small caps offer higher potential returns than large caps. The main reason is the “open runway” in front of them to grow and increase their market valuation. Larger companies have often already developed and faced fierce competition over the customer base. The downside to small caps is they hold greater investment risk. Think of boats in the ocean. A large ship will weather the storm better than a smaller boat.  Being in a speedboat in a storm will undoubtedly suffer. Similarly, the stock price of small caps can be more volatile than large caps and may even plunge to zero if the company fails.  There can also be fewer people trading shares of small-cap stocks – meaning lower “liquidity”, which inhibits open trading (i.e. your ability to buy/sell). Depending on your strategy and the type of investments you make will depend on whether small-cap stocks are right for you.  Small-cap stocks have more significant potential for growth than large-cap stocks. However, they also come with more risk. Small-caps may be a better investment if you are willing to tolerate more risk and have a longer time horizon. If you prefer stability and income from dividends, large-caps may suit you better.

Strategy implications for small-cap & large-cap stocks

Given the typically higher risk of small caps, investors must be comfortable with these risks before investing in them. If your risk tolerance is very low, for instance, then your portfolio may be better suited to “defensive” assets – such as stable, dividend-paying large caps and fixed-income securities (e.g. UK government bonds; or “gilts”).  However, if you have a long investment horizon in front of you – such as 10+ years – and are comfortable with more market volatility along the way, then including more small caps in your portfolio may be appropriate. Your overall investment strategy is essential. Are you looking to grow your wealth or preserve it? Someone in retirement is likely to be more focused on the latter – having already built up their wealth over their working life and now looking to draw on it sustainably to fund their retirement. On the other hand, young people starting their careers should focus more on growing their wealth in the decades ahead. You may be more inclined to invest in large caps, which are inclined to offer stock market price stability and pay a dividend. If you are looking to reinvest profits into the business and grow share price (rather than offer value to investors via a dividend) you should look at small caps.

How does it affect my portfolio risk?

The essential things to consider are your financial goals and strategy regarding small caps vs large caps. Do you want growth or preservation? How much risk are you willing to take? If you answer these questions, it will help you make the right decisions.  Are you interested in discussing your financial planning needs with a financial adviser financial planning needs? We’d love to assist you here at Hanson Financial Services. Please contact us to arrange a consultation with our team – free and without obligation – to gain clarity and peace of mind over your financial plan.   Important disclaimer: This content is for information and educational purposes only. You should not take it as financial or investment advice. Please book your free consultation today to receive tailored, regulated financial advice regarding your affairs.