You can find a company's total valuation, or market capitalization, by multiplying its stock price by its number of outstanding shares. For example, if a company's share price is $100 and it has 1 million outstanding shares, its market cap is $100 million. In terms of size, companies fall into three categories: small cap, mid cap, and large cap.

A small-cap company has a market cap of between $300 million and $2 billion, a mid-cap's is $2 billion to $10 billion, and a large-cap's is more than $10 billion. Investing in small-cap stocks carries risk, leading some to wonder whether to invest in them at all. Simply put, the answer is yes.

Someone holding a pile of money in one hand and a single bill in the other hand.

Image source: Getty Images.

Give yourself a chance for hypergrowth

Due to their size and financial resources, large-cap companies tend to be more stable and reliable than smaller companies. It's much easier to weather bad economic storms when you have billions in cash on hand. However, the size of large-cap companies also limits some of their growth potential. The opposite is true of small-cap stocks. Their size gives them much more room for growth, but because smaller size often translates to fewer resources, they're much more prone to volatility and susceptible to more economic conditions.

To truly have a diversified portfolio, you must invest in companies of all sizes. If you don't, you could be doing yourself a disservice and missing out on great companies with great potential. Take Amazon -- the world's fifth-largest public company, which has a market cap of over $900 billion -- as an example. It was once a small-cap stock, with an initial valuation of around $438 million at its initial public offering (IPO). Apple, the world's most valuable public company, was also a small-cap stock around its IPO.

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Amazon and Apple are, of course, once-in-a-generation companies and shouldn't be considered the norm, but if you never invest, you'll never give yourself a chance to get such returns. 

Lean on an index fund

Small-cap stocks are riskier, but one way to lessen the risk is by investing in a broad small-cap index fund that resembles the Russell 2000. The Russell 2000 tracks the smallest 2000 companies in the Russell 3000 index, and it's considered the primary benchmark for small-cap stocks -- as the S&P 500 is for large-cap stocks.

Russell 2000 index funds won't vary much, but you can't go wrong with the Vanguard Russell 2000 ETF (VTWO 0.21%) because of its low 0.10% expense ratio ($1 per $1,000 invested). The Vanguard Russell 2000 ETF is a one-stop shop for small-cap stocks, containing 1,970 companies covering all 11 major sectors:

  • Basic materials (4.00%)
  • Consumer discretionary (12.50%)
  • Consumer staples (3.20%)
  • Energy (7.30%)
  • Financials (17.60%)
  • Healthcare (16.40%)
  • Industrials (16.60%)
  • Real estate (6.40%)
  • Technology (10.40%)
  • Telecommunications (1.90%)
  • Utilities (3.70%)

There's no guarantee that any individual company will make it through rough economic times, but you can comfortably bet that a major index consisting of thousands of companies eventually will.

Be prepared for brighter days

Small-cap stocks usually get the short end of the stick during bear markets because investors flock to larger companies for the stability they can provide. Conversely, small-cap stocks tend to have more upside during the early stages of a bull market. During bull markets, prices usually increase faster than they drop during bear markets because investors rush to put more money into the stock market to take advantage. This works in favor of small-cap stocks.

During the Great Recession, the Russell 2000 dropped over 46% from September 2008 to March 2009; it's increased by over 380% since then. During the early stages of the COVID-19 pandemic in 2020, it dropped almost 40% from February to March; it's increased by over 86% since then.

Instead of letting this down period in the stock market discourage you from investing in small-cap stocks, view it as an opportunity to grab some great companies at a "discount" and set yourself up for future gains. You don't want the bulk of your portfolio to be small-cap stocks, but around 10% is a good baseline.