When it comes to investing, you need to make sure you have a well diversified portfolio so that you can lower your risk. A great way to add diversification to your portfolio is with small cap stocks. But the benefits of small cap stocks don’t end with just diversification.
There are many great reasons why you should invest a portion of your money in small cap stocks. In this post, I highlight 3 critical reasons why investing in small cap stocks will increase your long term gains. But first, we have to make sure you understand what a small cap stock is.
What Are Small Cap Stocks?
Small cap stocks are stocks of companies that have a market capitalization between $300 million to $2 billion dollars. The smaller the market capitalization, the smaller the company. The smallest of small cap stocks are usually referred to as micro cap stocks. But for the purposes of this post, we will focus on small cap stocks in general.
While reading market capitalization might not make complete sense to new investors, as a comparison as of this writing, the market capitalization of Apple is $937 billion. The market capitalization of Amazon is $770 billion. As you can see, the variance between small and large cap stocks is great.
Now that we know what a small cap stock is, let’s start looking at the benefits.
3 Reasons Small Cap Stocks Are Important To Invest In
#1. Diversification
As I stated earlier, small cap stocks allow you to further diversify your portfolio to lower your risk. This is important because the more exposure you have to various sectors and stocks with various market capitalization’s, the lower your overall risk.
Therefore, it makes sense as an investor to invest is not only large cap stocks, but also small cap and international stocks as well. In fact, to have the greatest diversification, when investing overseas, you should be investing in both small and large cap stocks as well. In most cases, small cap international stocks are referred to as emerging market stocks.
#2. Higher Returns
Another great thing about small cap stocks is they tend to earn a higher return. This makes sense as they are growing at a faster rate than large cap stocks. Since small companies are earning higher revenues, investors are willing to pay higher prices for the growth. The result is higher stock returns for investors.
Of course, on the flip side is greater potential loss as well. This makes sense when you think about it. Apple is a large, well established company. It’s revenues are predictable and as a result, its stock price is going to slowly move higher or lower for the most part.
But with a small cap stock, you risk losing a lot of money. This is because it is easier for a small company to have unpredictable revenues and even go out of business in a short period of time.
The good news though, is that by investing in high quality small cap mutual funds and exchange traded funds, you are buying a large number of small companies and diversify the risk of a couple losing revenues or even going out of business.
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#3. Long Term Performance
Over the long term, small cap stocks tend to outperform large cap stops by 2.3% annually. Over the course of 10 years, with $10,000 invested, this could result in an additional $5,000.
Taking the above point further, from 1979 through 2015, small cap stocks outperformed large cap stocks 54% of the time. So by investing in small cap stocks, you have a good chance of earning a higher return over the long term compared to large cap stocks and you can do so on a regular basis too.
Final Thoughts
To be a successful investor, you have to make a point to invest a portion of your money in small cap stocks. It will help you to have a better diversified portfolio and earn higher returns.
But you have to take into account your risk tolerance when deciding how large of percent of your portfolio should be invested in small cap stocks. This is because of the point above about these stocks being more risky than larger company stocks. Since they tend to earn higher returns, they also tend to be more volatile as well.
But by finding the correct allocation for you needs, you can invest in small cap stocks, earn a higher return and not worry about risking your money to a greater potential loss.
