Large-cap stocks and small-cap stocks: The two sound similar, but offer completely different risk profiles and return potential. Knowing how to distinguish the two is critical when building your own portfolio and managing investment expectations.
Here’s what investors need to know about large-caps and small-caps and their key differences.
What are large-cap stocks and small-cap stocks?
When investors discuss large-cap stocks and small-cap stocks, they are referring to the value of all the company’s outstanding shares, also called its market capitalization or market capitalization. This number is found by multiplying the total number of shares by the stock price.
For example, a company with 10 million shares outstanding selling for $10 per share would have a market capitalization of $100 million. This figure shows how valuable the audience is observes a company to be. The number can be determined by hype, popularity or other short-term optimism, as well as by estimates of a company’s long-term value.
Large-cap stocks are therefore stocks with a relatively large market capitalization, while small-cap stocks have relatively low market capitalizations.
Large capitalization stocks
Large-cap stocks, also called big-cap stocks, are the largest companies, typically with a market capitalization of $10 billion or more, although that threshold rises as more companies exceed it.
Large-cap stocks are generally considered safer investments than their mid- and small-cap counterparts because they are larger, more established companies with a proven track record. Some of the biggest names in business are large-cap stocks – Apple, Microsoft and Alphabet, for example.
Small capitalization stocks
Small-cap stocks are companies with a market capitalization of $300 million to $2 billion. Small caps are at the lower end of the market capitalization spectrum, and as they grow larger they can become mid-caps and eventually large caps if they achieve enough growth.
Small-cap stocks have historically outperformed their larger counterparts, but investments in this asset class should be approached with caution and appropriate risk tolerance. They typically offer higher returns in exchange for higher investment risk.
Key differences between large-cap and small-cap stocks
Although they are both stocks, large caps and small caps differ in some important ways.
Growth potential
Large-cap companies typically operate in mature but growing industries. Banking and the large technology sector are examples, although these sectors also have many small caps. Large-cap companies often have established operations, but with less room for growth.
“Large-cap stocks suffer from the financial theory of large numbers, which states that a large organization or collection that is expanding rapidly cannot sustain its rapid growth indefinitely,” said Bryan Shipley, CFA, chief investment officer of consulting firm Americh Massena. “As small businesses expand, high growth rates are easier to sustain.”
Small-cap companies, on the other hand, often operate in growing industries and may still be developing. The trade-off here is that small-cap companies have more room to grow and can offer investors higher returns, but with higher risk.
From 1926 through 2020, small-cap stocks outperformed large-cap stocks by an average of 1.6 percent, says Robert R. Johnson, Ph.D., professor of finance at the Heider College of Business at Creighton University. “That may not sound like a big difference, but with compounding the difference in return is enormous. One dollar invested in a large-cap index would have grown to $10,944.66 by the end of 2020. One dollar invested in a small-cap index would have grown to $41,977.83 by the end of 2020.”
Financial resources
Large cap companies will have different, and more robust, financial resources than small caps which are likely still under construction. Large caps tend to generate a lot of cash and will be more likely to be able to use their cash reserves to deal with potential problems. Large caps also have strong stocks that they can use to raise capital in the event of a recession. In addition, they have easier borrowing options than small caps due to their track record and size.
Large caps often also own other assets (such as existing cash, stocks, real estate, stores, equipment, merchandise and more) against which they can borrow. Small caps may have more limited resources and have a harder time raising money in the debt markets.
Inconstancy
Volatility is another key difference between small-caps and large-caps. Small-cap companies are often earlier in their life cycle and may be more susceptible to economic downturns, which could cause their operations to suffer or access to financing to dry up. These factors can lead to greater volatility for small-cap stocks.
In contrast, large caps tend to experience less fluctuation in the value of their stocks. Their business and financial resources are deeper and stronger, and their competitive position allows them to recover faster, while small caps may not survive similar droughts. If they do, they will experience more volatile swings in value than their larger counterparts.
Dividends
Large-cap companies are much more likely to pay dividends to their investors than small-cap companies. Larger, more stable companies operate in mature, slower-growing industries and are often cash cows that can distribute profits to their shareholders. Smaller, emerging companies, on the other hand, often operate in fast-growing industries and need to invest in growth. So they do not have the financial resources to pay dividends.
Business power
A key difference between large caps and small caps is the overall strength of their business.
Large-cap companies are “able to absorb costs better than small caps, negotiate with suppliers or even pass costs on to consumers more easily than small caps,” said Anessa Custovic, Ph.D., Chief Investment Officer , from Chapel Hill, North Carolina. -based cardinal retirement planning. “This means that profits are less likely to fall if costs rise because they can absorb this. They may be less sensitive to consumer confidence and macroeconomic conditions because they are larger and more established.”
Large caps also tend to have more diversified businesses, which also helps during recessions. Small caps, on the other hand, tend to be more focused on a few industries, so they are more sensitive if something happens to one of those companies.
Which one should you choose for your portfolio?
The choice between large-caps and small-caps ultimately comes down to your goals and how much risk you’re willing to tolerate, but both have their place in a well-diversified portfolio.
- Large caps: Stable returns with less room to grow. Possible dividend payments.
- Small caps: More volatile, but with potential for growth and higher returns.
- Mixed approach: Diversification of the volatility of small caps, hedged by possible dividend payments and/or small, stable returns by large caps. A higher ratio of large-cap to small-cap will be the safest way to start.
“If your goal is long-term wealth accumulation, history would suggest that small caps are preferred over large caps,” Johnson adds. This obviously comes with the price of volatility and the ability to weather a potential looming downturn.
A buy-and-hold strategy works for both, but an investor should expect varied returns.
In short
Both large- and small-cap stocks have value in one’s portfolio.
Large-cap stocks are investment mainstays that provide stability and consistency through their size, breadth and financial resources they can draw on to hedge downturns and sometimes even pay dividends to their investors.
Small-cap stocks are riskier and more volatile investments because they do not have the same financial resources as large caps and are still developing their businesses. They all have their purpose for investors: small caps can offer growth but will be risky, while large caps have less room for growth but will offer less volatility.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
