Small caps, large caps & your portfolio

This content is for information and educational purposes only. It should not be taken as financial advice or investment advice. To receive tailored, regulated financial advice regarding your affairs please consult us here at Hanson Financial Services (financial advice in Liverpool). Does the size of the companies in your investment portfolio matter to your returns? Many seem to think so. One common argument is that smaller companies (“small caps”) tend to offer higher returns than larger ones (“large caps”) because they have more capacity to grow. However, their smaller size also makes them more vulnerable to economic shocks. In this article, our team at Hanson Financial Services (financial advice in Liverpool) explores the differences between small and large caps, how both can impact investment return and some implications for your portfolio strategy. We hope you find this content useful and please get in touch if you’d like to discuss your financial plan with us.

Small & large caps

Generally, both small and large caps are publicly-traded stocks. The word “cap” refers to the “market capitalisation” (market cap) of the stocks. Simply put, the market cap is the value assigned to a company on the stock market. This is calculated by multiplying the current share price by the total number of shares. So, at the time of writing, Amazon has a market cap of $1.82tn. This is because the share price was $3,580.41 and there were 507.15m (therefore, 3,580.41 x 507,150,000 is about $1.82tn). This is an exceptionally high market cap – placing Amazon firmly in the category of “large cap”. However, large caps are commonly understood to refer to stocks with a market cap of at least $10bn. Examples include Intel ($202bn), Royal Dutch Shell ($169.59bn) and Legal & General (£17.79bn). The US has some public companies which far exceed these valuations – such as Apple ($2.66tn), Google ($1.95tn) and Microsoft ($2.54tn). If the share price of a company goes down, therefore, then its market cap will also fall (due to the calculation above). This is what is meant when you hear news about a company “losing X amount from its market value”, and it can mean that a stock can move between the “large” and “small” cap categories. (A small cap is usually understood as a stock worth between $300m to $2bn). The important 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 “edge” of small caps

Various studies have indicated that small caps can offer higher potential returns compared to large caps. The main reason is due to the “open runway” in front of them, to grow and increase their market valuation along the way. Larger companies, by contrast, have often already grown and face fierce competition over the customer base. The downside to small caps, however, is that they can come with greater investment risk. Think of ships in the sea. A large vessel will likely be able to weather a storm better than a speedboat or sailboat. The latter could sink if conditions get too fierce, and will certainly be tossed about, regardless. 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).

Strategy implications

Given the typically higher risk of small caps, it is important that investors are comfortable with these risks prior to 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 important. For instance, are you looking primarily 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 in a sustainable way to fund their retirement. However, a young person starting out in their career will likely want to focus more on growing their wealth in the decades ahead – ready for their future retirement. The former person may be more inclined to invest in large caps, therefore, which are more likely to offer stock market price stability and possibly pay a dividend. Yet the latter person may be more attracted to small caps which are looking to reinvest profits into their business and grow their share price (rather than offer value to investors via a dividend).

Conclusion & invitation

When it comes to small caps vs large caps, the important things to consider are your goals and your strategy. Do you want growth or preservation? How much risk are you willing to take? Answering these questions will help you make the right decisions.  Are you interested in talking to a financial adviser about your 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 more clarity and peace of mind over your financial plan.