Small-Cap Stocks: Pros and Cons

If you've ever wished you could have invested in some terrific giant companies back when they were young, you're essentially hankering for promising small-cap stocks. It makes sense to hanker for promising small-cap stocks, too, because they have the most room to grow. As you might imagine, though, it's not enough to just favor small-cap stocks. Like any other investment, they offer advantages and disadvantages.

Before we review some pros and cons of small-cap stocks, know that there's no single universal definition of a small-cap stock. One rule of thumb is an enterprise with a market capitalization ("market cap") of about $250 million to $1 billion. (Companies with valued below $250 million can be thought of as micro caps.)

The good
The first upside of small-cap stocks is their great growth potential. Growth potential doesn't always turn into growth, though, so choose your small stocks carefully, and don't put all your eggs in just one or a few small baskets.

Small-cap stocks can also grow more quickly than their larger counterparts, and an added bonus is that they tend to be underfollowed on Wall Street. That's because if a company is small, the big investors, such as mutual funds and pension funds, have little use for it, because they can't buy all of the company, and the portion they might buy would not have much effect on their overall portfolio. Thus, we small investors can often get into small companies before the big money does. And if we've chosen well, and the stock grows big, its share price will get a further boost as the big guys eventually pile in. We also have a better chance of discovering some undervalued gems among small-cap stocks, because they've been less scrutinized and traded by the big investors.

Small-cap stocks offer useful diversification, too, as some investing periods offer outperformance by large-cap companies, and other periods are dominated by small-cap performances. Meanwhile, each small-cap company can be more focused than large companies, as many haven't yet expanded into new lines of business in search of new dollars. They're busy trying to grow the business they're in now. As large companies tend to be more stable and slower growing, adding some small caps to your portfolio can give it a better chance of performing better.

The bad
So what's bad about small cap stocks? Well, for one thing, they can be quite volatile. That isn't necessarily bad, but some investors don't have the stomach for wild swings. (Note that such volatility is a plus, too, providing some opportunities to jump into a great stock at a great price.)

Small-cap stocks have less certain futures, too. A small company might have a terrific technology or product, but not end up succeeding if it doesn't have enough cash to bring the product to market and achieve profitability. In other words, small-cap stocks are riskier.

Dividends can be hard to find among small-cap stocks, too -- though plenty of such companies do pay dividends. Smaller companies typically need to spend every extra dollar on growing their businesses, while big, established companies with reliable profit streams, sometimes have more cash than they can productively deploy.

Some small-cap stocks are really small, and may even be penny stocks -- trading for less than about $5 per share. These tend to be extra risky and best avoided. Don't confuse small-cap stocks and penny stocks. A great small-cap stock might be priced at $8 or $28 or $128 per share, and may still be a bargain. Ideally, and unlike many penny stocks, it will have a solid track record of growing revenue (and perhaps even growing profits), because it has actual products or services that it's selling. It will have an informative website, too, and lots of financial reports to peruse.

Make it easy
A great way to incorporate small-cap stocks into your portfolio is to invest significantly in inexpensive index funds that track the broad market. An S&P 500-focused index fund will only hold those 500 large companies, but a fund such as the Vanguard Total Stock Market Fund (NASDAQMUTFUND: VTSMX  ) will invest in almost all of the U.S. stock market, instantly plunking you into large and small companies alike. You can go even broader with funds such as the Vanguard Total World Stock Market ETF (NYSEMKT: VT  ) . They charge just 0.17%and 0.19% in expenses per year, respectively, and have about 6% and 5% of their assets in small-cap stocks. (For a richer allocation, the Vanguard Small Cap Index Fund (NASDAQMUTFUND: NAESX  ) sports an expense fee of 0.24% and has about 48% of its assets in small-cap stocks --and more than 40% in mid-caps.)

One way or another, consider small-cap stocks for your portfolio.

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