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Understanding the Risks of Small Cap Stocks

Jason BondJason Bond ·

Small cap stock trading is quite attractive, especially for those day traders and swing traders who cannot spend on huge deposits. However, if this type of investing was such easy and profitable, then all the investors would switch to small cap stocks and would become wealthy. Yet, you should know that before becoming successful with trading small cap stocks, you have to deal with their risks.

Think carefully about the risks described below, and come with a counterbalance to mitigate these. Here they are – the 7 risks associated with investing in small cap stocks:

Low trading liquidity

It is clear that small cap stocks are not such exposed to trading in comparison to large cap stocks, being less liquid. This suggests that there are not enough share sellers so that we could satisfy our buying needs, or that we would not be easy to sell our shares at a decent price, because there are not so many buyers. In addition to this, a lower trading liquidity is about higher commissions and fees per transaction, so you should check this with your broker.

Kiran Kavikondala, director of Wealth Rays, says: “liquidity & longer waiting period (for selling) are the two main issues when it comes to taking a decision on investing in small-cap stocks“, thus, showing how important low trading liquidity may be especially in the bearish markets.

Limited access to capital

Generally, small companies struggle with financial issues more frequently than larger companies. This is because of limited financial resources and a narrow door to capital. This means that whenever there is a crisis, industry downtrend, or a new chance to grow, there is much harder to get financing.

No operating history

A third risk type that can make your trading activity more difficult is the lack of operating histories related to small cap stocks. Also, they cannot prove a business model that was confirmed to show results – it is especially true about the young companies. If a mega cap company would fail with some of its product launches or services, it would start again and would try to minimize the negative effects. Let’s think about the Volkswagen’s diesel scandal – did the company collapse because of it? No, it has some difficult moments, but it goes on. This luxury is not possible for small companies because sometimes their product launch may be a onetime chance. Also, the small companies don’t have a loyal customer base that would keep on buying continually.

Lack of information

When it comes to small companies, it is natural that there is less information available about them. For example, you will be surprised to see that dozens of Wall Street analysts are covering a single stock, such as Apple or Microsoft, but no one talks about companies with market cap under $2 billion. You should do your own research and sometimes it is difficult and time consuming. The financial media is the same – they deal with something that can bring more views, and it is surely not about small cap stocks. The good news is that there are some portals and blogs that are exclusively focused on small cap stocks – you can benefit from it.

Market Fluctuations

Because of a decreased trading liquidity, most of the small cap stocks would behave quite randomly at first sight, being very volatile. The volatility is actually one of the most important risks that should be considered by beginners. It is common for a stock to drop 5% within a day, and then jump on some positive reports. Sometimes it is enough for an investor to buy or sell several hundred shares and he would be able to move the price up or down.

Prime Acquisitions

Sometimes the small companies may become interesting for their big rivals – the monopolies. The latter can decide to acquire them since they find that particular small caps may have huge potential. Even if prime acquisitions can pay very high those who own small cap stocks, in the long-term, you would not be so glad to lose a company with excellent growth potential for future market domination.

The management team

One of the greatest challenges for small cap stock investors is to build their trust in relation to the management team. You can see that large companies organize conferences, publish different reports whenever a new team member is added or fired, and so on. With the small companies things are different. Sometimes the management team has no experience at ruling a company and tries their luck for the first time. You never know what you can get in the end.

As an investor, you should look for a management team that has a vision and a great business idea, can recognize and accept the mistakes, and has some knowledge of the industry.

In conclusion, despite the risk of small cap stock trading, there are many great opportunities that can boost your portfolio. The higher the risk, the higher the potential profit – this rule is true about any investing activity. The good news is that you can mitigate the risks and look for small cap stocks that are not such exposed to the risks described above, and there are many such stocks.

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