How Small Cap Stocks Differ from Large Cap Stocks in Risk

Although small-cap stocks are considered riskier investments than large-cap stocks, enough small-cap stocks are offering excellent growth potential and high potential returns on equity (ROE) to warrant their inclusion in the holdings of all but the most conservative investors.

The 4 Risks of Small-Caps

There are four primary aspects of small-cap stocks that make them potentially riskier than large-cap stocks.

1. One is that, when it comes to trading, small-cap stocks have less liquidity. For investors, this means enough shares at the right price may be unavailable when they wish to buy—or it may be difficult to sell shares quickly at favorable prices.
2. Another aspect is that, in comparison to large-cap companies, small-cap firms generally have less access to capital and, overall, not as many financial resources. This makes it difficult for smaller companies to obtain the necessary financing to bridge gaps in cash flow, fund new market growth pursuits, or undertake large capital expenditures. This problem can become more severe for small-cap companies during lows in the economic cycle.
3. The third aspect of potential added risk with small-cap stocks is simply a lack of operational history and the potential for its unproven business model to prove faulty. These two factors can make it difficult for smaller companies to compete with larger companies effectively. Because small companies are not as likely to have an established, loyal customer base, they are more vulnerable to consumer preference changes.
4. The fourth aspect of risk with small-cap companies has to do with data. Not as much information about small companies is commonly available to the public, and this makes an informed evaluation of small-cap stocks more difficult for potential investors.

Advantages of Small-Caps

Despite the additional risk of small-cap stocks, there are good arguments for investing in them. One advantage is that it is easier for small companies to generate proportionately large growth rates. Sales of $500,000 can be doubled a lot more easily than sales of $5 million. Compare this to large-cap growth, where $50 million in sales is a lot more difficult to translate into $500 million.

Also, since a small, intimate managerial staff often runs smaller companies, they can more quickly adapt to changing market conditions in somewhat the same way it is easier for a small boat to change course than it is for a large ocean liner.

Another advantage of investing in small-cap stocks is the potential for discovering unknown value. The general rule of the investment world is that the majority of Wall Street research is aimed at a fraction of publicly traded companies, and most of these companies are large caps. Small-cap companies fly more under the radar and, therefore, hold greater potential for those seeking undervalued stocks.

The Bottom Line

Lack of market liquidity can sometimes be of benefit to small-cap investors who already own shares. If large numbers suddenly seek to buy a less-liquid stock, it can drive up the price faster and further than it would for a more liquid stock. Good portfolio management includes mixing in a moderate proportion of well-chosen small-cap stocks with less volatile large-cap stocks. It is precisely because there are different levels of risk between large- and small-cap stocks that market capitalization of the equities is a key consideration in achieving proper diversification in an investment portfolio.