Market cap, or market capitalization, is the total value of a company’s outstanding shares. This is calculated by multiplying the number of shares and the company’s share price. For example, on a recent day, IBM’s closing stock price was $138.56 and it had 896.80 million shares outstanding. Therefore, its market cap was $124.261 billion.
Market cap is related to the size of the company. Large-cap stocks represent shares in larger companies. These tend to be more well-known and established. Small cap stocks represent shares in less established, smaller companies.
Both types of stocks can have a place in a well-diversified portfolio. However, investors need to understand the investment implications, including the risks, of both types of stocks.
What are large-cap stocks?
Large-cap stocks are defined as those with a market capitalization of at least $10 billion. Examples of large-cap stocks are such well-known names as Apple (AAPL), Microsoft (MSFT) and JPMorgan Chase & Co. (JPM). Morningstar defines domestic large-cap stocks as those in the top 70% of the U.S. market capitalization.
Domestic large-cap stocks are tracked by indexes such as the S&P 500 and the Russell 1000. Large-cap stocks are further broken down by those that are considered growth versus value stocks. Stocks of companies located outside of the U.S. are classified by market cap as well, and there are also mutual funds and exchange-traded funds that track foreign large-cap stocks.
Large caps are generally more established companies with one or more lines of business. They generally have well-developed internal systems and balance sheets.
What are small-cap stocks?
Small-cap stocks are generally those with a market cap ranging from $300 million to about $2 billion. Small-cap companies tend to be newer and may be serving niche markets. They often have more limited financial resources and are just building their internal business structure. The Russell 2000 index is a key small-cap index.
Small caps can be risky, but they also offer solid growth potential if the company is successful and experiences growth in its business. The company’s balance sheet and financial structure may not be as solid as many large-cap companies.
In looking at the Vanguard Small Cap ETF (VB), a small-cap index ETF, the top three holdings in the fund on a recent day were Bio-Techne Corp., Diamondback Energy Inc., and VICI Properties Inc.. As you can see, none of these are household names.
Large-cap vs. small-cap stocks: 3 important differences
There are a number of differences between large-cap and small-cap stocks. Before deciding on an investing strategy, it's important to understand these differences to help you determine where to invest and what percentage of your portfolio belongs in either or both types of stock.
Small-cap stocks are generally higher risk than large caps. This is because many small caps are newer companies. They may lack the depth and experience in their management compared with large-cap counterparts. Their balance sheets and overall financial structure may be weaker as well.
Many small caps are in a single line of business or at least offer a limited number of products or services. If there are issues with their main business line, either internal or due to market conditions, this could severely impact the company.
On the other hand, large caps are often more stable companies with a strong management team and a solid balance sheet. They are likely to have multiple products, which allows them to better weather volatility in the economy and customer preferences.
With added risk and smaller size, small caps can offer the potential for solid and in some cases spectacular growth. Names such as Apple, Google, and Microsoft were once small caps and long-term shareholders have been rewarded handsomely. This isn’t always the case. But as the saying goes: no risk, no reward.
This isn’t to say that large caps cannot and do not experience periods of high growth, some stocks do. This will vary widely based on the company, their industry, and other factors.
In many cases, large caps will tend toward slower, more steady growth. Large tech stocks like Apple may grow at a faster pace compared with large caps in other, more basic industry sectors such as manufacturing.
Large-cap stocks are more likely to offer a steady and sometimes increasing dividend yield than small caps.
Small caps may be more focused on growth and want to reinvest profits back into the business to help fuel that growth. Many large caps, in contrast, are not in as rapid a growth mode and don’t need all or as much of their profits to be reinvested back into the business. They declare a dividend and distribute these profits back to their shareholders as dividends. If you look at a list of dividend stocks, you’ll likely recognize a number of their names.
One investment strategy revolves around purchasing shares in companies that consistently pay dividends and increase their payout ratio over time. Consistent and increasing dividend payouts can also be a sign of a well-managed company that is financially strong.
Alternatives to consider
Certainly investing directly in individual large-cap or small-cap stocks can be an option for individual investors. In the case of large-cap stocks, these names are widely followed and there is a wealth of information on the internet about these companies and their track records.
Small-cap stocks are generally less widely followed and the level of available information is often less than that of large-cap stocks. Additionally, the trading volume of some small caps may be less than that for large caps. This can potentially make the purchase of the shares more expensive, and reduce the amount received when selling shares.
In both cases, for newer investors or those with smaller portfolios, buying individual stocks can result in concentrated positions. In other words, if these stock positions represent an outsized percentage of your investment portfolio, you run the risk of excessive losses if any of these stocks experiences a drastic downturn in value.
A smart alternative to buying into individual companies on the stock market, might be to consider funds instead.
Small-cap vs. large-cap funds
There are many mutual funds and ETFs available that focus on both large-cap and small-cap stocks. Within large and small caps there are funds and ETFs that focus on value stocks, growth stocks, and a blend of the two styles. Both large-cap and small-cap mutual funds and ETFs offer professionally managed portfolios.
Beyond small cap versus large cap, you will also need to investigate active versus passive investing approaches. There are actively managed mutual funds and index mutual funds. In the ETF space, the vast majority of ETFs tend to be passively managed index products.
Especially with small-cap stocks, using a professionally managed vehicle like a mutual fund or an ETFs makes a lot of sense for most investors, and certainly for newer investors or those with a limited amount of investable assets. Even for more experienced investors, it's difficult to research many of the companies that comprise the small-cap space. ETFs and mutual funds are a much more efficient way for most investors to invest in small caps.
The best brokerage accounts tend to offer a wide range of both mutual funds and ETFs in these asset classes. Overall, ETFs and mutual funds make investing in a well-diversified portfolio easier for most investors. This includes not only large and small-cap stocks, but includes virtually all asset classes. It's also much easier to rebalance your portfolio using mutual funds and ETFs.
There are a number of index mutual funds and ETFs that invest in both large- and small-cap stocks. These funds will track an index and do their best to replicate both the performance and makeup of the index.
Funds and ETFs that track the S&P 500 index are a good example. The Vanguard 500 Index fund is offered as both a mutual fund and an ETF. The fund replicates the performance of a key large-cap stock index.
An example of an index fund that replicates a small-cap index is the Vanguard Small Cap index fund. This is also offered as both a mutual fund and an ETF. In this case, the fund tracks the CRSP Small Cap Index, which tracks the U.S. small-cap market.
The benefit of using index funds to invest in large caps, small caps, and other asset classes is that these funds tend to be true to their investment objective. This makes the asset allocation process much easier versus worrying about whether an actively managed fund is staying true to its objective or experiencing style drift away from its core asset class.
Which is better: small cap or large cap?
Neither small caps or large caps are better or worse than the other. A well-diversified portfolio will often hold both types of stocks. There are even mid-cap companies with valuations that fall between small- and large-cap companies. The real issue is how much of your portfolio should be allocated to any given type of stock. The answer will depend upon your objectives, time horizon, and risk tolerance.
Do you need small-cap stocks in your portfolio?
Small-cap stocks can be a key part of a well-diversified portfolio. Whether you need them or if they are appropriate depends on your own unique investing goals and situation. Some investors may find their growth potential appealing. Others might be turned off by their risk.
It’s important to understand the differences between large-cap and small-cap stocks when investing money. Both can be key parts of a well-diversified portfolio. Small caps tend to be riskier based on their size and other factors. Large caps are often the core portion of a portfolio.
Mutual funds and ETFs can be great tools for investing in both large and small-cap stocks for many investors. This makes the asset allocation process much easier and can help in achieving the diversification needed for smaller investors.
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