If you don’t have much experience buying and trading stocks, the terminology can be confusing. One of the most difficult topics to understand is market capitalization – but it is something you need to understand if you want to become a wise investor.
At Addition Financial, our valued members often ask us investment questions. One of the most common has to do with the differences between large cap, mid cap and small cap stocks, as well as micro cap stocks.
Because this is a complex topic, we wanted to share some basic definitions as well as some tips from our financial experts about the benefits and risks of large cap stocks and small cap stocks. Here’s what you need to know before you invest.
Since some of our members may be new to investing in the stock market, let’s start with a definition of market capitalization. Market capitalization is a term that refers to the total market value of all shares in a company. The actual dollar amount of any company’s stock value fluctuates constantly, but whatever the total is, that is the company’s market capitalization.
Market capitalization is used in a variety of ways to evaluate stock and determine whether a company is a good investment risk. For example, you can divide the market capitalization by the 12-month net earnings of a company to calculate the price-to-earnings ratio.
Stock may be classified in a number of ways. You may hear terms such as common stock and preferred stock. You may also hear people use the abbreviation “cap” to refer to capitalization. Here are some helpful terms to know:
Most of the stocks you hear mentioned by name are large cap stocks. While the number may change, it’s a good rule of thumb that a company that has large cap stock must have a market capitalization of at least $10 billion. These stocks tend to be reliable and steady.
As their name suggests, mid cap stocks rest in a middle ground between large and small cap stocks. Most mid cap stocks have a market capitalization total between $2 billion and $10 billion.
Small cap stocks are typically from smaller companies that may be more volatile than larger companies. These stocks come from companies with a market capitalization total below $2 billion.
While these terms are not as well known, you may also hear references to mega cap stocks, which are issued by companies with a market capitalization of $1 trillion or more. By contrast, micro cap stocks typically come from companies with a market capitalization total between $50 million and $1 billion.
As a beginning investor, you may wonder whether it’s best to buy large cap stocks or small cap stocks. We asked some financial experts to give us their best advice about using market capitalization to choose investments. Here’s what they told us.
Large cap stocks are mostly from well-known companies. Some examples of large cap stocks include Apple, Microsoft, Johnson & Johnson and Visa.
Jenna Lofton is a Certified Financial Advisor at StockHitter.com. She told us:
“For investors looking to make quick moves with little research, [large] caps are better because there is less risk involved. Also, large cap companies are easy to spot so it doesn't take long to figure out whether or not a stock might do well (for example Facebook or Apple will most likely always do well).”
If you’re someone who prefers predictable investments with steady growth, then large cap stocks are a good choice.
Shannon Terrell, a Senior Investments Writer at Finder, agrees. She told us this:
“Large-cap stocks come from well-established companies with a proven track record and a market cap over $10 billion – think Amazon, Facebook and Microsoft. They’re typically more expensive than small- and medium-cap stocks – but they’re considered to be a safer investment.”
In other words, large cap stocks typically come with a higher price tag than small cap stocks and they have less growth potential. Stock market investments should be diversified to include some stocks of the “slow and steady” variety and growth stocks that have the potential to exponentially increase your wealth.
In addition to buying large cap stocks, it’s a good idea to diversify your portfolio by buying some medium, small and micro cap stocks. Here’s what our experts said about them.
Raj Patel of Financeshed made several points about the benefits and risks of investing in smaller stocks. He told us:
“Shares of medium, small and micro-cap stocks are lower in rates [and] therefore affordable for investors and can be bought in quantity. Small and medium caps tend to grow faster than large cap stocks. Small cap companies have the ability to outperform large cap companies.”
He also pointed out some risks of investing in medium, small and micro cap stocks:
“The invested amount can be [held] for a longer period of time. The price may not increase as rapidly in micro-cap shares than it does on large-cap stocks, but the reverse can also be true. [Also] small-cap stocks have less liquidity and so it may be difficult to buy the shares at the right price and sell the shares at favourable prices. Micro, small and medium-cap stocks have more volatility during rough markets than large-cap stocks.”
Shannon Terrell echoed many of the same statements, telling us this:
“Small- and medium-cap stocks come from smaller companies and tend to be more volatile, but they also offer the potential for growth.”
You may be noticing a pattern here. Large cap stocks offer stability, but they come with higher prices and less potential for significant growth. Medium and small cap stocks have lower price tags and more volatility, both of which are balanced by the potential for higher gains.
Jenna Lofton clarified this issue, telling us:
“Investing in medium, small and micro-cap stocks will provide you with a higher risk/reward than large cap stocks. The reason is that investors have a greater chance at making great returns on their investments as these companies may be relatively unknown but they also can lose more money if the company does not perform well or goes out of business.”
You should keep these considerations in mind when deciding which types of stock to invest in.
One of the things you can do to minimize the risk of investing in the stock market is to diversify your portfolio. That can mean choosing different types of investment accounts. For example, for most people, investing only in the stock market is a bad choice because the risk of losing most of your money exists. You can mitigate the risk by investing in a combination of stocks, bonds and other investment vehicles with lower risk.
What does capitalization have to do with diversification? Even within your stock portfolio, it’s possible to spread out your investments and minimize your risks. For example, a portfolio consisting only of small and micro cap stocks would be risky because of the potential volatility of small companies.
On the flip side, a portfolio consisting only of large cap or mega cap stocks might be too conservative to help you meet your long term goals. You would see some growth but it would likely be of the “slow and steady” variety, meaning that you wouldn’t be taking full advantage of the earning potential of the stock market.
Here are some tips from the experts we’ve quoted above to help you diversify your portfolio:
Whether you work with a financial advisor or use a robo advisor, you should be aware of what your portfolio looks like and where your risk is. That way, you can adjust it as needed to prevent major losses.
Understanding market capitalization and the differences between large cap stocks and small cap stocks can help you to make the most of your investments while preventing major losses.
Are you ready to get started investing in the stock market? Click here to learn about the MEMBERS Financial Services program at Addition Financial and book an appointment with a CUNA advisor.