Small-Cap Stocks

Market capitalization, or market cap, is a measurement of the total market value of a publicly traded stock. The larger the market capitalization, the larger the footprint of the company in question — and the more money it would take to acquire all of the company’s shares. Market capitalization can be calculated as follows:

For example, a company with stock trading at $25 per share and 40 million shares outstanding would have a market capitalization of $1 billion ($25 × 40,000,000 = $1,000,000,000).

In addition to serving as a gauge for comparing companies’ market values, market capitalization is an important metric used for index-linked investing, also known as passive investing. This widely popular method of investing is a low-cost way to replicate the returns of an index rather than trying to outperform it.

Index-linked investing involves the establishment of an investment fund or strategy with positions that mirror an index. A metric such as market capitalization or stock price is used to establish the relative positions and proportions.

For example, you can replicate the performance of the Russell 2000 Index, which tracks the performance of approximately 2,000 of the smallest publicly traded companies in the United States, by buying positions in the constituent companies and maintaining the appropriate proportions of those positions over time based on their market capitalization. Essentially, this means buying more of the stock of outperforming companies and selling the stock of the underperforming companies.

A small-cap stock refers to a company with a small market capitalization, or a relatively small total market value compared to other publicly traded companies. At a high-level, the universe of publicly traded companies consists of small-cap, mid-cap and large-cap companies. In financial terms, the distinction is generally broken down as follows:

It’s important to note that small-cap stocks should not be confused with startup companies. While some startups can be considered small-cap stocks, not all small-caps are startups. Many small-cap stocks have long track records of strong financial results, and they just haven’t yet crossed the measurement threshold to be categorized as mid-cap or large-cap. Examples of small-cap stocks include Abercrombie & Fitch Co., Dave & Buster’s Entertainment Inc., Genworth Financial Inc. and Office Depot (ODP Corp).

If you decide that investing in small-cap stocks makes sense for you, you can purchase small-cap stocks through your brokerage firm or your financial advisor. These days, it’s increasingly common to make these purchases via an online brokerage firm such as Charles Schwab, E-Trade or Fidelity Investments. Brokerage firms can facilitate your trades, maintain pertinent records and safeguard your investments in a low-cost manner.

That said, unless you’re an experienced securities analyst with plenty of free time, buying individual stocks is not recommended, as there is just too much risk. If you’re new to investing or just getting started with small-cap stocks, a fund-style investment such as an exchange traded fund (ETF) is a good way to go.

Pooled investment vehicles like ETFs offer hassle-free, low-cost and diversified access to an array of markets and market segments. When it comes to the domestic small-cap space, most people consider the Russell 2000 to be the best stock market index. Two other widely followed small-cap indexes include the MSCI USA Small Cap Index and the S&P 600 Index.

Beyond the differences in market value, small-cap stocks tend to be less mature than mid-caps and large-caps. As a result, they usually have much greater potential for growth, but they also experience more erratic cash flows and volatility in stock price than larger companies.

That said, small-cap stocks like those in the Russell 2000 Index can outperform their larger counterparts such as those in the S&P 500 Index when you compare their performance over an extended period. This concept is illustrated below for the 20-year period that ended June 17, 2022.

While the performance of small-cap stocks in the Russell 2000 was clearly superior for much of the 20-year period, the margin of outperformance has largely been erased in 2022. This is largely due to anxiety from high inflation and aggressive Fed rate-hike action to blunt the trend. During times like this, small-caps are hit much harder than larger companies, mainly due to their relatively erratic cash flows and smaller financial reserves — both of which translate to greater risk for investors.

Unfortunately, until the economic uncertainty subsides, small-cap stocks are likely to continue to lag behind the performance of larger companies. Nevertheless, over the long-term, small-caps hold a lot of promise and should be included as part of any portfolio diversification. Leaving small-caps out of your portfolio, even while investing during inflation, can have a serious drag on your return on investment in the long term.

All investment opportunities involve some risk, but as described above, volatility is even greater when you invest in small-cap stocks. You can help mitigate this risk by diversifying your portfolio, but only to a certain extent. Investing in small-cap stocks will expose you to a much higher degree of volatility than you will have with most other asset classes, such as large-cap stocks in the Standard & Poor’s 500 Index (S&P 500).

The growth potential of small-cap stocks can overshadow the risks, but you’ll want to consider your investment horizon carefully and understand that it only makes sense to invest in small-cap stocks if you can let them grow and appreciate for at least 5 years. Ideally, you should let them grow and appreciate much longer.

A financial advisor can help guide you through the process of assessing your tolerance for risk and learning the process of investing for beginners, which includes understanding both your ability and your willingness to take on risk. You can also find investment advice and a risk tolerance quiz online.

If you’re interested in investing in a small-cap ETF, take a look at the funds below. They are among the largest and most diversified ETFs in the market. All are relatively low-cost and sensible for anyone seeking passive, small-cap exposure.