Any serious conversation about investing inevitably includes a discussion about “cap size.” There are solid proponents of large-cap stocks, ever-hopeful fans of small caps, and in-between mid-cap fans.
But what exactly does a cap size designation mean and, more importantly, why does it matter?
Cap size refers to a company’s market capitalization (i.e. its value on the stock market). The number of shares a company has outstanding multiplied by share price determines its value.
Generally speaking, large-cap stocks refer to the stock of a company valued more than
$10 billion. Mid caps are valued between $2-10 billion and small caps are below $1 billion to $2 billion.
So why does this matter?
The performance between the three categories can be quite different. In fact, since 2001, the cumulative return of the popular small-cap benchmark index Russell 2000, has been over 80 percent. During that same time, the cumulative return of large caps tracked by the S&P 500 Index was just north of 15 percent.
So why not just throw everything in small caps?
You could, but you’d better be ready to hang on. Small-cap companies tend to be young, emerging companies showing great promise and strong gains. However, the risk associated with these newcomers is still fairly high. While there’s a chance a small cap may be tomorrow’s industry leader, there’s also a good chance they’ll stay small for some time.
On the other hand, large-cap companies tend to be more stable and less likely to have their earnings fluctuate dramatically like a small company. But the downside to that stability is slower growth rates.
Understanding the classes of stock you own is the first step to determining how to rotate your money through them to increase your rate of return or mitigate losses.
Historically, the different classes perform differently during different economic cycles. Small caps tend to perform well in the early stages of an economic upturn. But they also tend to get beat up much worse during downturns. On the other hand, large caps perform best near the end of economic cycles and even through poor economic cycles. Plus, large caps pay dividends so even when the market’s taking a beating, you may at least eke out a bit of pay off from dividends.
So what’s the best strategy?
That depends…on the economy, your risk-tolerance, and your ability and willingness to stay on top of the market.
The best advice is to pay attention to overall economic trends, follow specific assets classes, and be willing to rotate among classes.
Granted, that’s no magic formula, but simply understanding what you have can go a long way to making sure you have more of it in the future.