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Stocks represent ownership in companies of various sizes. Understanding the relationship between company size, return potential, and risk is crucial if you're creating a long-term investment strategy. With this knowledge, you'll be better prepared to build a balanced stock portfolio that comprises a mix of market caps.
Sizing up stocks
Typically, companies are categorized in one of three broad groups based on their size — large-cap, midcap, and small-cap. Cap is short for market capitalization, which is the value of a company on the open market.
Market cap definitions can vary, so the following are general guidelines.
- Large-cap: Market value of $10 billion or more; generally mature, well-known companies within established industries.
- Midcap: Market value between $3 billion and $10 billion; typically established companies within industries experiencing or expected to experience rapid growth.
- Small-cap: Market value of $3 billion or less; tend to be young companies that serve niche markets or emerging industries.
To calculate a company's market capitalization, multiply its stock's current price by the total number of outstanding shares. For example, if a company issues one million shares of stock trading at $50 each, its market capitalization is $50 million ($50 times 1,000,000 shares).
Evaluating risk and reward potential
Generally, market capitalization corresponds to a company's stage in its business development. Typically, investments in large-cap stocks are considered more conservative than investments in small-cap or midcap stocks, potentially posing less risk in exchange for less aggressive growth potential. In turn, midcap stocks generally fall between large caps and small caps on the risk/return spectrum.
Why? Midcap companies may be in the process of increasing market share and improving overall competitiveness. This stage of growth is likely to determine whether a company eventually lives up to its full potential. Midcap stocks generally fall between large caps and small caps on the risk/return spectrum. Midcaps may offer more growth potential. Therefore, midcaps may offer more growth potential than large caps.Footnote1
The relatively limited resources of small-cap companies may make their stocks more susceptible to a business or economic downturn, and they could also be vulnerable to the intense competition and uncertainties of untried markets. On the other hand, small-cap stocks may offer significant growth potential to long-term investors who can tolerate volatile stock price swings in the short term.Footnote2
A standard method of gauging the performance of an investment is to measure its returns against those of an index representing similar investments. As with stocks, indexes come in all sizes and shapes. The Standard & Poor's (S&P) 500 is the best-known yardstick for large-cap stocks. As their names suggest, the S&P MidCap 400 and S&P SmallCap 600 indexes represent midcap and small-cap stocks, respectively. The Russell 2000 is another prominent index for small-cap stocks.Footnote3
Selecting the right combination
Over time, large-cap, midcap, and small-cap stocks have taken turns leading the market as each can be affected differently by market or economic developments. That's why many investors diversify, maintaining a mix of market caps in their portfolios. When large caps are declining in value, small caps or midcaps may be on the way up and could potentially help compensate for any losses.
To build a portfolio with a proper mix of small-cap, midcap, and large-cap stocks, you'll need to evaluate your financial goals, risk tolerance, and time horizon. A diversified portfolio that contains a variety of market caps may help reduce investment risk in any one area and support the pursuit of your long-term financial goals.
Keep in mind, diversification does not eliminate risk or the risk of potential loss.
Next steps
- Learn more about stocks
- Read about the importance of asset allocation when choosing investments
Footnote1 Stocks of midcap companies pose special risks, including possible illiquidity and greater price volatility than stocks of larger, more established companies.
Footnote2 Stocks of small-cap companies pose special risks, including possible illiquidity and greater price volatility than stocks of larger, more established companies.
Footnote3 The S&P 500, S&P MidCap 400, S&P SmallCap 600, and the Russell 2000 are unmanaged. It is not possible to invest directly in an index. Past performance is not a guarantee of future results.
© SS&C. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions.
The material was authored by a third party, DST Retirement Solutions, LLC, an SS&C company ("SS&C"), not affiliated with Merrill or any of its affiliates and is for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Merrill or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is in your best interest based on your particular circ*mstances and, if necessary, seek professional advice.
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