So you heard from a friend that small-cap investing is a great way to create long-term wealth, but you are unsure how much
Well, there is no perfect answer because everyone’s situation is different, but there are ways to better understand your investment goals and how to effectively achieve them through small-cap investing.
In this article, we explain small caps in more detail, why you should invest in them, and how to determine a suitable investment amount that meets your individual needs.
What is a Small-Cap Stock?
A small-cap stock is defined as any publicly traded company trading at a market cap between $300 million and $2 billion.
As small companies, small caps tend to be more volatile than mid-caps and large-cap stocks, meaning their stock price tends to fluctuate more drastically than larger companies.
For this reason, many investors perceive small-cap stocks as riskier, given that their long-term stock price and market cap are less predictable.
While true to some extent, the riskiness of a stock is ultimately determined by the underlying fundamentals of business. A company with a healthy balance sheet and consistent growth is bound to be less risky than a shrinking business with boatloads of debt.
Therefore, an investor in individual stocks should not associate risk merely with the size of the company but instead with the economic factors stimulating or hindering the business.
To learn more about what a small-cap stock is, check out the article here.
How Much Should I invest in Small Cap Stocks?
There is no perfect answer for determining how much you should invest in small-cap stocks. Still, there are ways to help improve your understanding of your investment needs while also achieving the small-cap exposure you desire.
Here are a few ways to help determine how much you should invest in small-cap stocks.
One of the first things every investor should do is figure out their investment time horizon.
Are you retiring, beginning your professional career, or investing so your kids can go to college?
Whatever your reason for investing might be, it is valuable to paint a clear picture of how long you plan to invest so that you can begin planning your stock portfolio accordingly.
As a general rule of thumb, the more time you have to invest, the better.
Since small caps are generally considered to be high-risk, high-reward bets, most investors believe that it is better to have a short time horizon so that they can profit on near-term fluctuations in their stock price.
However, this assumption is incorrect because in order for the wonders of compound interest to take effect, it often requires many years before the best investment returns are actualized.
For example, in Tesla’s ($TSLA) first ten years of trading, the company jumped from a stock-split adjusted price of $1.33 to $43.37, meaning that you would’ve netted a solid return of 2,622.62% since its IPO.
But if you chose to hold onto your shares for just another two years, you could have earned a total return of 23,853.96%, as the stock reached its all-time high of $381.59 in 2021 (note $TSLA has fallen to $122.40 due to recent market corrections).
Although this is merely an example of what is possible, the outcome holds for many stocks, especially if they are early-stage businesses like small caps.
Therefore, if you have a longer time horizon at your disposal, this is your best chance to invest in small-cap stocks because you are more likely to realize better annual returns as your investment journey unfolds.
Dividends or Growth?
As an investor, is your goal to earn passive income through dividends, or are you planning on generating the highest returns?
If you are striving to put some extra cash in your pocket, then it is probably best that your investment strategy focuses less on small-cap stocks and more so on mature large caps that pay consistent dividends instead.
That is because small-cap companies often choose to forego paying dividends to reinvest their earnings back into the business either through growth projects or stock buy-backs.
Though it may not feel like it at the moment, a business that chooses to reinvest its cash is often the better option for investors seeking higher returns, given that the company is taking action to improve its competitive position and, thus, its market cap value.
Now, depending on what level of growth you are trying to accomplish, you may choose to allocate more of your portfolio into small caps if you do not require the capital gains right away.
On the other hand, if you are expecting to pull your investment in a shorter period, it is probably best that you create a diversified portfolio with both small and large caps to ensure that your returns are available.
While there is no wrong choice here, the growth investor is probably better suited to invest in small-cap stocks because they do not require a dividend and are comfortable leaving the
Overall, it is smart to evaluate your investment goals and determine the appropriate small-cap asset allocation for you.
Active or Passive Investing?
Though we often talk about individual small-cap stocks on our platform, not everyone wants to actively invest, meaning that they would much prefer to buy a small-cap index, like the Russell 2000, or small-cap ETF, like the iShares Core S&P Small-Cap ETF, and leave their stock portfolio alone.
This is an excellent way to diversify into small-cap stocks without running the risk of choosing individual smaller companies.
For example, by investing in an index that tracks the Russell 2000, you gain ownership of 2000 of America’s small-cap companies, and all you have to do is click a single button.
Even better, small-cap indexes rebalance your portfolio automatically, meaning that you never have to worry about removing bad businesses on your own.
Overall, indexes and ETFs are a fantastic way to gain exposure to small-cap stock while eliminating many of the risks that exist when you buy a small-cap company.
Pros and Cons of Investing in Small Cap Stocks
Like any investment vehicle, there are reasons for investing in small caps and reasons to avoid them.
Taking time to understand both sides of the story will help you gain a clearer picture of whether or not investing in small-cap stocks is suitable for you.
In this section, we break down the pros and cons of investing in small-cap stocks.
Small-Cap Investing Pro #1: High Growth Potential
Unlike large-cap stocks or mid-cap stocks, small-caps tend to have higher growth potential than most businesses, meaning that they will likely generate superior returns in the long run.
Since they are often in the growth phase of the business cycle, these early-stage companies tend to reinvest all of their profits back into the business, which eventually leads to a bigger market cap value as investors realize its worth.
In doing so, a small-cap stock can easily double, triple, or 100x its market cap, depending on the type of business, the industry it operates in, and who is managing it.
Though not always the case, small-cap investing can lead to better investment returns if an investor takes the time to find small-cap companies with the strongest business fundamentals.
Small-Cap Investing Pro #2: More Investment Opportunities
Not everyone has the opportunity to invest in small-cap stocks.
Well, to be clear, everyone has an opportunity to buy small caps, but it isn’t always worthwhile for an investor to do so.
For example, big institutional investors like hedge funds and mutual funds may be discouraged from investing in small-cap companies if they are too small compared to the fund’s assets under management.
Therefore, these financial advisors usually opt for more established companies like large companies or large-cap indexes because they are more likely to generate meaningful returns for their shareholders. This relates to the size of the investment, not the relative return on investment.
On the flip side, this isn’t the case for most retail investors, given that most of us are not working with millions of dollars, let alone billions.
As such, we have broader access to the various types of investment vehicles that exist (i.e., micro caps and small caps), meaning that there are more opportunities for us to find diamonds in the rough.
Ultimately, it is valuable to be aware of all the options that exist in the stock market so that you can do some financial planning and build a portfolio that is best suited for you.
For more reasons why you should buy small-cap stocks, check out our article here.
Small-Cap Investing Con #1: Small Caps are Volatile
With less liquidity than mid-cap stocks or large-cap stocks, small-cap stocks tend to be more volatile, meaning that their stock price fluctuates more dramatically.
Though this is not a direct risk to the performance of the business, owning volatile stocks can be discouraging to investors who are seeking stability and comfort.
Perhaps you may be retiring shortly, and you want to guarantee that your investments will steadily grow over time.
If that is the case, then it is probably best to avoid small-cap stocks and, instead, focus on mature, dividend-paying stocks so that you are more confident in what the outcome will be.
Small-Cap Investing Con #2: Less Predictable
Since small caps are usually early-stage businesses, these companies tend to have limited financial information, meaning that it can be difficult for investors to predict where they might be headed.
While we would argue that an investor should not rely solely on past performance to forecast future results, having access to previous records is incredibly valuable because it demonstrates what the company is capable of and whether it delivers on its objectives or not.
Therefore, the more years under a business’s belt, the better understanding an investor has about how a business will perform because they can determine what they do during various economic environments.
In addition, when a business has more financial data, it is easier to figure out what the stock is worth because a company’s annual growth rate and future cash flows become more apparent.
All-in-all, the more information you have on a stock, the better.
Wrapping it Up
If you want to invest in small-cap stocks but are unsure how much to invest in them, a good idea is to evaluate your current investment goals and determine whether or not small caps will help you accomplish them.
Since there is no perfect answer, understanding your investment horizon, financial standing, risk tolerance, and more will help you figure out what is an appropriate amount and whether you should be investing in small caps at all.
Ultimately, there is only one way to truly understand how much to invest, and that is by investing.