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Why Your Portfolio Needs Small Cap Stocks

Jason BondJason Bond ·

Many investors want to make sure their stock picking is right and involves minimal risks. This is why they would generally look for value, and big company names would make sense in most of the cases. They say:

  • Monopolies have long term potential and you cannot bring down such monsters as Facebook or Google.

  • Big companies pay high dividends;

  • Generally, large cap stocks have sufficient historical performance to satisfy your concerns about how solid a company is; also, there are many news and reports that can favor an in-depth research.

  • There is less volatility, which opens the door for more stability.

Yet, do the large cap stock trading pros diminish or overshadow the small cap stocks’ advantages? No way. Every investor must know that a healthy asset allocation within a portfolio cannot be possible without small cap stocks, especially today.

To make things clear to newbie audience:

Small cap, from small capitalization, refers to companies that have a smaller than average market capitalization – the title says it all, right? Now, when getting to the figures, most of the investors agree that a small cap company would generally have a market capitalization from $250 million to $2 billion.  

Now, let’s continue with our subject – why should one consider investing in small cap stocks?

The first reason you should think about small companies is their potential growth. Let’s have a look at this chart:

The chart above shows the evolutions of Microsoft, Apple, Google, Facebook and Amazon throughout the years – all of them are mega cap companies. You can see that Apple has over $600 billion market cap, Google – over $500 billion, Microsoft – close to $500 billion, and Amazon and Facebook – over $300 billion. This is great, but can you see where all of these started? Almost all of the largest companies today started as small cap companies, with a few exceptions like Facebook and Google, which entered the market with over $50 billion.

Can you image Apple or Microsoft as a small cap stock? Well, they were at some point, and many of the small cap stocks today may reach that far.

However, this was only a point – it does not mean you should expect from your small cap stocks to double and triple their value every month and year. It simply doesn’t work like this. The main thing you should understand and consider is the percentage return potential.

Patrick O’Hare, chief market analyst at Briefing.com, explained it very well when he said: “Small-cap stocks are seen as having stronger growth potential simply because they are small companies”.

To understand the percentage return potential, let’s do a simple math. When a large cap company like Google adds $1 billion to its $500 billion, this is a 0.2% growth. However, when a billion dollar company adds the same value, this represents a 100% growth. Can you see the difference? As an investor, you would be interested in the percentage return because this is about your own return. Here is the visual difference between 0.2%, 100% and 200%:

This can be your return, so you should think about it.

The second reason why you should consider small cap stocks refers to the today’s conditions of the stock market per general. You can note that the S&P 500 and Dow Jones, the indexes that depend on large caps, are in a state of overbought. You can feel all this fever of Dow Jones hitting the 20,000 mark here and there. But, can these indexes go up forever? Let us consider the past performance of S&P 500 and Dow Jones indexes:

You can see the sudden drop during the dot com bubble (after the peak 1) and the 2008 crisis caused by the housing bubble (peak 2). Do you see how far both indexes reached today? They are updating their records again and again – the stock market is clearly in the overbought level and I don’t feel the big companies have much space above. It is very important to analyze the impact of Trump policies and see what changes can they bring to the stock market space, but the large cap companies are quite limited today.

Instead, switching to small cap stocks, even if not entirely, can refresh your portfolio. The small cap companies have more potential because the general overbought state does not affect them.

Whenever the broad economic conditions improve, the impact on small cap stocks is immediate. Today, the stabilizing oil prices, the increase in interest rates by the Fed and the economic stimulus will surely support particularly the small cap stocks. The President-elect Donald Trump is ready to push a massive stimulus into the economy. For large cap companies, $10 million in extra contracts doesn’t represent a difference, but this amount would surely be a huge impulse for small companies.

I will finish this post with a chart that may help you understand the benefit of positive economic changes for the small cap stocks. Here is the recent performance of Russell 2000 index, the one that represents small cap stocks, against S&P 500:

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