Small-cap stocks are one of the three major types of stocks based on market value or market capitalization. These stocks are issued and traded by companies with a market cap of between $300 million and $2 billion. Note that the range of figures varied depending on the geographic market or the standard in a particular stock market.
There are several advantages to investing in small companies compared with mid-cap stocks and large-cap stocks. Adding them to your portfolio can help you meet your investment goals and objectives. However, there are also disadvantages or drawbacks and notable risks. This article lists and discusses the pros and cons of small-cap stocks.
A Look Into the Pros and Cons of Small-Cap Investing
Pros: Advantages of Small-Cap Stocks
Most valuable companies today started as small-cap stocks. Consider Apple and Amazon as notable examples. The potential of small and even startup companies to grow into one of the largest entities in their particular industry and sector represent the collective advantages of investing in small-cap stocks. The following are the specific benefits:
1. Affordable Compared to Mid-Cap and Large-Cap Stocks
Remember that supply and demand are some of the factors that affect stock prices. Stocks from larger and more established publicly-traded companies tend to be expensive because they are in demand. These stocks also experience high volumes of trading on a day-to-day basis. However, due to fewer demands, stocks from smaller companies are relatively inexpensive and more accessible than mid-cap and large-cap stocks
2. Long-Term Growth Potential of Promising Small-Cap Stocks
Another advantage of small-cap stocks is their potential to grow or appreciate well-above stock indices in the long run. Remember that even the largest companies today were once small startups. For example, Apple stock traded below $1.00 per share from the 1990s to the early 2000s but now trades between $150.00 to $170.00. Investors can maximize the long-term benefits of purchasing and holding promising small-cap stocks.
3. More Accessible and Advantageous to Individual Investors
Note that institutional investors often choose mid-cap and large-cap stocks. Pooled fund managers such as mutual funds are limited to investing in larger companies because small-cap companies do not have the market cap to support large investments while regulators restrict the investment decisions of these pooled fund managers. Hence, individual investors usually have the first-to-invest advantage when it comes to investing in small-cap stocks.
4. Potential to Leverage Market Inefficiencies in Small-Cap Stocks
Analysts and the media tend to focus their attention on larger companies. They give little to no attention to smaller companies trading small-cap stocks. The result is that small-cap stocks have a higher probability of improperly priced or being undervalued. This situation creates huge potential and opportunities for investors to leverage the inefficiencies in market pricing to earn substantial returns in the future.
Cons: Disadvantages of Small-Cap Stocks
The promises of small-cap investing can help individuals maximize further the advantages of investing in stocks. However, compared with mid-cap and large-cap stocks, small-cap stocks tend to be more volatile due to the management and directional uncertainties that come with startups and smaller companies. The following are the specific disadvantages:
1. Have Higher Risk and More Suitable for Aggressive Investors
Investing in the stock market is riskier than other assets and securities such as bonds and the money market. However, small-cap stocks are even riskier than mid-cap and large-cap stocks. Nevertheless, one of the disadvantages of small-cap stocks is that they are more suitable for investors with an aggressive risk profile. Those who have less aggressive, as well as moderate to conservative profiles are better off picking other assets and securities.
2. Specific Issues of Investing in Startup and Smaller Companies
The fact remains that startups and even established but smaller companies tend to be less insulated from market volatility, as well as greater market and economic downturns. Furthermore, leadership at these organizations still lacks the experience or track record. Their business model might also lack the soundness required to succeed. These companies also have less access to capital or investments, thereby making them more volatile.
3. Limited Trading Volume and Less Liquid Than Larger Companies
Another drawback of small-cap investing and trading is that the trading volume is low. Holders might have a hard time finding interested buyers in the stock market. In certain instances, interested investors might also have a hard time finding stockholders to buy from. The volume of stocks a small-cap company trades is limited. These stocks are fundamentally less liquid than mid-cap and large-cap stocks because of these trading challenges.
4. Transparency Challenges and the Lack of Relevant Information
Remember that analysts and the media tend to focus their attention on larger companies and rarely on smaller companies. Investors interested to invest in small-cap stocks need to depend solely on the information provided by the issuing companies and some unreliable sources. Hence, another critical challenge of small-cap investing is that there tends to be less information that can help individuals come up with informed investment decisions.
Important Pointers Before Investing in Small-Cap Stocks
The aforesaid advantages of small-cap stocks can help individuals achieve their investment goals and objectives. However, not all stocks are created the same. Buying small-cap stocks does not guarantee attaining the benefits mentioned above. The disadvantages of small-cap investing should be taken into careful consideration.
Nevertheless, like in investing in other assets and securities, it is important for an investor to ask himself or herself relevant questions that can help him or her guide his or her investment decisions. Furthermore, one should be aware of his or her risk profile or risk tolerance. Research also plays an important role in maximizing the advantages of small-cap stocks.
