To visualize the differences between small-cap and large-cap stocks, let’s imagine that you own a farm. You hope to boost your farm’s income by buying an apple tree. Since apples are a high-margin item, a quality apple tree should give your bottom line a slight boost.
You head to an orchard and come across two potential options to buy. One tree is full-grown, very expensive, and is not quite the biggest tree you’ve ever seen. The other tree is a small sapling that you can buy for a fraction of the price. Let’s consider the different benefits of buying each tree:
The full-grown apple tree has clearly been there for years. This makes it a safer bet because you know that it can survive storms, pests, etc. On top of that, you also know that it’s going to produce fruit for you each year. However, since this tree is already full-grown it’s not very likely that it’s going to grow a whole lot bigger. It also comes with a higher price tag.
On the other hand, the sapling is only about a year old and it doesn’t produce fruit yet. However, the owner of the orchard tells you that the sapling is a different species of tree. Due to this, he expects that it will grow much larger than the full-grown tree. By buying the sapling at a cheaper price, you could end up making much more money in the future. However, that’s also assuming that the tree doesn’t get uprooted during the next big thunderstorm.
In a nutshell, this is the difference between small-cap and large-cap stocks. In this scenario, the big tree is a large-cap stock and the sapling would be a small-cap stock.
When you buy a large-cap stock you’re usually making the safer decision and are comfortable with the return on your investment that you will earn. On the other hand, if you buy a small-cap stock, you’re making a calculated risk that it will grow much bigger in the future and potentially provide a larger return than the large-cap stock.
We’ve already gone pretty in-depth about the pros and cons of investing in small-cap stocks, so let’s take a look at large-cap stocks.
Large-cap stocks are companies with a market capitalization of $10 billion or more. Compare this to small-cap stocks, which have a market capitalization of $2 billion or less.
There are plenty of benefits to investing in large-cap stocks:
- Stability – Just like the full-grown apple tree has strong roots, large-cap stocks are companies that are large and well-established. It’s unlikely that these companies will go out of business anytime soon. Their stock prices are also relatively stable, which means that your money should be safe from potential downturns.
- Dividends – The full-grown apple tree also already produces fruit each year. In the same sense, large-cap stocks are known for consistently paying dividends. Many large-cap stocks have a dividend history that goes back for decades. This means that you can still expect to receive a return on your money even if the shares you own are not appreciating in value each year.
- Less research required – If you are considering investing in a company like Google then there is no shortage of information available. Google puts out tons of reports for investors that are professionally done. On top of this, every time Google releases their financial earnings, there will most likely be hundreds of analysts breaking down what this new information means for Google and its stock price. Although you should never invest purely off of other people’s research or opinions, this availability of information will make your job a lot easier.
So what are some of the downsides to investing in large-cap stocks?
- Lower growth expectations – Since these companies are already so massive, it is not likely that their business will double in one year. Their stock price might still increase every year, but it’s unlikely that it will outperform the return of the overall market.
- Slower to pivot – Being large and well-established can sometimes be a disadvantage. If there is a massive change in the industry then larger companies are generally slower to react when compared to smaller companies.
- Opportunity cost – Most people only have so much money to invest. When you choose to invest in a large-cap stock, it means that you will lose out on the potential gains of investing in small-cap stocks.
- Capital risk – Despite their size, no company is invincible. Even when you invest in a larger company there is still a risk that their business and stock price will take a dive.
As with most investment decisions, there really isn’t a right or wrong answer. Instead, it just depends on what you are looking for as an investor. Just like with the apple tree, you are essentially trying to balance the risk you are taking with a return that you are comfortable with over a certain time period. This is why most investors usually include a mix of both large and small-cap stocks in their portfolios.