When you show up to a new gym, it’s very unlikely that your personal trainer will start your workout right when you show up. Instead, they will probably spend a few minutes asking about your fitness goals. They’ll want to know things like:
- What is your main reason for working out?
- How many weeks/months/years do you plan on working out for?
- What is your past experience with fitness?
The answers to these questions will help your trainer determine the type of workout routine that’s best for you. It’s important that they know these answers because different fitness goals will require very different workout routines.
For example, if you are mainly focused on dropping 10-20 pounds before the summer months arrive then they’ll set you up with a plan that has lots of cardio.
On the other hand, if you are mainly focused on getting stronger for an upcoming sports season then they’ll put you on a plan that has lots of heavy lifting.
It’s not that either of these workout routines is better than the other. They are just designed to help you reach different objectives. This same mentality is true when it comes to investing. For the most part, your best investment plan will depend on your financial goals and objectives.
With that said, just like practically every workout program will include some type of cardio, practically all portfolios should include some exposure to small-cap stocks. This is because small-cap stocks provide several key benefits that can help boost your returns.
Here are a few of the main benefits of small-cap stocks:
- Potential for larger returns – A sapling is most likely going to grow much bigger each year when compared to a full-grown Redwood. Since Redwoods are already gigantic, most of their high-growth years are behind them. Similarly, smaller companies generally have much more room to grow than larger ones. This is mainly because it’s easier to grow $5 million of revenue by 20% annually than it is to grow $5 billion of revenue. Due to this potential for revenue growth, small-cap stocks have the potential to experience years of returns that could be bigger than the overall market.
- Potential to find hidden gems – Pretty much everybody in America has heard of the massive technology company Apple. Apple receives tons of attention from financial analysts and the news media. Due to this, it’s safe to assume that Apple’s stock price reflects all available information. However, there are plenty of smaller companies that don’t receive the attention that Apple does. These companies might have amazing business fundamentals that have not been recognized by the market. This is known as information inefficiency. If you’re able to identify these types of “hidden gems” then you have the potential to earn a lot of money.
- Less competition from institutional investors – Larger investing entities such as hedge funds are generally less interested in small-cap stocks. In some cases, large investors may even be restricted from trading in small-cap stocks due to their market cap, liquidity concerns, etc. Again, this can create opportunities to identify overlooked gems.
- Lower share prices – Small-cap stocks generally have lower share prices. This makes it easier to buy a large stake in a small-cap company with a relatively small investment.
- Higher historical returns – Due to their growth potential, indexes of small-cap stocks generally tend to outperform larger ones over the long run.
- Easier access to management teams – Since they are much smaller companies, it’s generally easier to get in contact with the management team of a small-cap stock. If you had a question, it’s much more likely that the CEO of a small-cap stock would answer an email compared to the CEO of Apple.
With that said, there are downsides associated with every investment. Here are the main downsides of investing in small-cap stocks:
- Higher risk – Unlike a company like Apple, small-cap stocks have business models that are much less proven. This means that their stock price can fluctuate greatly based on news updates. One small misstep by the company’s management can have huge negative side effects for the company and its stock price.
- More time-consuming – Is it a good idea to buy stock in a company like Apple? Without doing any research, most people will probably feel comfortable nodding yes to this question. This is because Apple is one of the most valuable companies in the world and tons of analysis on their stock is readily available. However, most small-cap stocks are not nearly as well known. This means that it will take much more time and due diligence to determine if they’re worth investing in.
- Lower liquidity – Since they are smaller companies, it can sometimes be harder to buy/sell shares of stock for the price that you want.
- Higher volatility – Small-cap stocks generally have fewer shares outstanding. This can lead to increased volatility in the stock’s price.
To summarize, we’ll leave you with the description of two different investors. The description that sounds like it fits your personality will help you determine whether small-cap stocks are a good investment for you.
Investor #1:
You take an active role in managing your portfolio and are constantly searching for the next stock with high potential. This time investment gives you an opportunity to maximize your portfolio’s returns and possibly outperform even the biggest hedge funds. Even if someone else manages your money, you don’t mind them taking some risk as long as you are confident that the potential reward will be worth it.
Investor #2:
You want to be financially secure but you have way too much going on to really focus on investing in stocks. In an ideal world, you would just want someone else to handle your investments for you. You would rather sleep soundly at night knowing that your money is safe instead of constantly chasing higher returns.
If you’re more like Investor #1 then you should consider upping your exposure to small-cap stocks. On the other hand, if Investor #2 sounds more like you then it might be a good idea to minimize your exposure to small-cap stocks.