If you’re just getting started in the world of investing, you may have heard terms like small-cap and large-cap when an investment opportunity is described.
“Caps” in the stock market aren’t like caps on the top of a bottle — the term doesn’t describe a stopping point or a limit. Instead, a company’s market cap, or market capitalization, is used to describe the total dollar value of a company.
Companies are grouped together by overall size based on their total dollar value. These groups include:
- Nano-Caps. Nano-cap stocks are a form of penny stock. These stocks trade with a market capitalization of under $50 million, with the vast majority of companies this size trading on the over-the-counter (OTC) market, meaning they not traded on a large exchange such as the Nasdaq or the New York Stock Exchange (NYSE).
- Micro-Caps. Micro-cap stocks are another form of penny stock. The key difference is that these stocks trade with market caps between $50 million and $300 million. The vast majority of these stocks also trade on the OTC market.
- Small-Caps. Small-cap stocks are the smallest stocks ahead of penny stocks and are generally traded on traditional exchanges like the NYSE and the Nasdaq. These stocks trade with market caps ranging from $300 million to $2 billion.
- Mid-Caps. Mid-cap stocks are larger, more established companies, but haven’t quite hit the blockbuster stage. These stocks trade with a market cap ranging between $2 billion and $10 billion.
- Large-Caps. Finally, most large-cap stocks are also within the blue chip category. These are the behemoths of the stock market, trading with market caps of more than $10 billion.
What Market Cap Tells You
Sure, market capitalization tells you exactly the size of a company in dollars and cents, but it goes far beyond that. Market capitalization is a great way for investors to gauge the risk associated with an investment.
The companies with the biggest market capitalizations earned their positions through strong sales, branding, and an ability to take over their markets. As such, they are the least likely to fail and the most likely to generate stable returns for your investment portfolio.
Think about it this way: you haven’t heard of most penny stocks. When one of these tiny companies folds, few people even notice. However, large-cap stocks like Amazon are very different.
If you’re like most people, you would be absolutely shocked if you learned that Amazon was filing for bankruptcy or shutting down. After all, Amazon is a household name; the company is responsible for about half of e-commerce business in the United States, according to Techcrunch.
On the other hand, large-cap stocks do have their drawbacks. Although they tend to come with stable growth, dividends, and far less risk than their smaller peers, the opportunity for dramatic, fast-paced gains in value is diminished when a company is already massive.
Looking at the other end of the spectrum, penny stocks that fall into the micro-cap and nano-cap categories come with incredibly high risk. These companies often are in the development phase or have a product that hasn’t quite taken off among its target audience.
The vast majority of penny stocks have extremely high levels of debt, and it’s rare to see profits among these tiny players. As a result, these companies are often at the mercy of lenders and the investing community, leading to the danger of dilution through transactions like common stock offerings that hurt share prices for existing shareholders.
However, penny stocks aren’t all bad. Although there is plenty of risk to consider with them, the reward can be incredible.
For example, if you were to invest in Microsoft when it was a penny stock, you would have owned a piece of what would become a world-leading tech giant. Riding that wave from the $0.10 mark in 1996 to today’s value of more than $200 per share would have been a highly lucrative endeavor.
The same can be seen across various sectors, like ExxonMobil in energy, Pfizer in biotechnology, or UnitedHealth in the financial services and insurance industry. All were tiny companies when they first started before they grew to become dominant players in their respective industries.
You simply can’t get in on these dramatic runs if you’re not willing to play with the pennies.
Small-cap stocks aren’t quite as risky as penny stocks but are nowhere near as safe as large-cap stocks. These companies are generally out of the development stage and are just entering the commercial stage.
Like penny stocks, most small-cap companies are still struggling with profitability, sometimes leading to transactions to pay debts or raise money that aren’t in the best interest of current investors. However, there are some perks to graduating from penny stocks to small-cap stocks.
Small-cap stocks often trade on large exchanges like the Nasdaq. This is important because access through a large exchange helps to improve the chances of liquidity — that is, your ability to sell stock that you’ve purchased. This is unlike most penny stocks, which generally trade on OTC markets and are riddled with liquidity issues.
A company being at the small-cap stage adds liquidity and offers a bit more confidence to its investors, giving them access to potentially tremendous gains with slightly less risk than is involved with penny plays.
For many investors, the mid-cap category is the sweet spot. Companies in the mid-cap range have developed products or services that investors value to a tune of billions of dollars, rather than tens or hundreds of millions.
The vast majority of mid-cap companies have worked their way to profits, alleviating the majority of risk associated with dilutive transactions. They also generally trade on major stock exchanges with high volume, helping to alleviate liquidity risks.
That’s not to say that mid-cap stocks don’t come with risks of their own.
At this stage, investors are banking on the mid-cap companies they invest in breaking into the blockbuster category. Although these companies are already large and generally profitable, they haven’t yet exerted dominance and taken over the market
Sales may be just on the brink, branding may be just around the corner, or some other factor could propel the company into explosive growth. Until it does — whatever that catalyst is — many of these mid-cap stocks can plateau without breaking into the large-cap category.
Nonetheless, the risks here are far lower than the risks you take when investing in penny and small-cap stocks.
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How Much Should You Invest in These Cap Groups?
How much to invest in each type of stock is a tough question to answer, largely because there is no one-size-fits-all answer. In the world of investing, asset allocation is an intimate process that takes into account unique aspects of your financial life.
Ask yourself the following questions to put together the perfect allocation strategy for you.
How Old Are You?
The first factor you should take into account when determining allocation is your age.
A key part of investing is allowing time for gains to compound. You also don’t want to expose yourself to too much risk or volatility as you approach retirement when your portfolio has less time to recover from losses.
As such, your allocation can be a bit riskier when you’re young and should skew toward less risk and more stable growth as you age.
Ultimately, your time horizon should play a factor in your growth. If you have 15 or 20 years to recover if a poor investment decision costs you money, you have plenty of time to absorb the risk associated with investing in stocks with lower market caps.
On the other hand, if you are nearing retirement and have less than 10 years left for your investments to grow for you, you’re better off investing in more stable stocks with higher market caps. It’s also a good idea to use bonds as a way to balance risk.
What Are Your Goals?
This is a question you should think long and hard about. What are your goals when you make an investment? Are you looking for dramatic growth? Are you looking for stability in your portfolio? Are you hoping to bank on dividends?
If you’re looking for stable growth or dividends, your best bet would be to invest in large-cap stocks only. Although these stocks aren’t likely to go on any spectacular runs in value any time soon, they are likely to continue on an upward trajectory and keep your money safe.
Moreover, once companies hit the large-cap category, their profits are generally pretty big. As a result, a large portion of stocks in this category pay decent dividends.
If you’re relatively young and have money, you can afford to lose — with ample time to recover in case that happens — you may be looking for dramatic growth. High-risk penny and small-cap stocks offer opportunities for just such massive growth.
After all, if these stocks hit it big, the investor stands the chance of multiplying their investment several times over. However, keep in mind that penny and small-cap stocks come with increased risk and could result in significant losses when things go badly.
How Much Money Do You Have to Start With?
Investing is all about putting up your own money in the hopes that it grows within the investment vehicle of your choice. How much money you have to start with will play a role in how that money is allocated.
If you’re starting with anything less than $1,000, you shouldn’t even consider high-risk options. Conventional wisdom says you should never have more than 5% of your investing capital tied up in high-risk investments at any given time unless you’re a professional with a deep understanding of the stock market.
However, it generally takes a relatively large investment in order to benefit significantly from big stock price movements, the way an investor in penny and small-cap stocks would be hoping.
A small stock doubling in price is certainly exciting, but it’s less meaningful if you could only afford to invest $50 in it.
With small dollar amounts yielding returns that aren’t worth the risk, penny and small-cap stocks should only be considered by investors with portfolio values over $1,000.
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How Experienced Are You?
Your experience should play a key role in your decision as to which category of stocks to invest in. If you’re a beginner, you should steer clear of risk until you have a deeper understanding of how the market works, your potential rewards, and the risks involved in making an investment.
As such, beginner investors should focus exclusively on large-cap stocks. Doing so will greatly reduce risk while providing access to stable, long-run gains.
Once you have an adequate understanding of how the stock market works and the risks you take when making an investment, if you still want to invest in small-cap or penny stocks, start slow. It’s best to test your strategy with small dollar amounts before jumping all-in on high-risk investment opportunities.
How Much of a Risk Are You Willing to Take?
If this article has taught you anything, it should be that market cap isn’t only about overall value, but also about risk. As the market cap gets larger, risk dies down. Conversely, when market caps shrink, risk expands.
Considering this, when choosing how much of your portfolio should be invested in the various cap categories, you should always consider your appetite for risk.
If you have a tolerance for risk, there’s no shame in investing 100% of your stock allocation dollars into large-cap stocks and enjoying stable growth from well-established stocks that pay dividends.
If you’re looking for a little more thrill and have a larger appetite for risk, consider mixing in a larger portion of mid-cap and small-cap stocks. Of course, you can consider penny stocks too, but keep these to a minimum in order to protect your portfolio from significant losses.
At the end of the day, while all the other factors will play a role, it all begins and ends with how much risk you’re willing to absorb.
When risking your hard-earned dollars on any investment, it’s important to gain a deep understanding of what your investment dollars are being used to build.
Although market capitalization won’t tell you everything, it’s an important indicator of the risk/reward profile associated with a stock. The lower the market cap, the more you risk when making an investment, and vice versa. As such, it’s always important to look at a stock’s market cap before making a final investment decision.
Always remember, educated investing is the key to stock-market success.