Small Cap Stocks: What They Are & How to Invest in Them

Investing
Updated: 18th Dec 2020
Written by Sean Graytok
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Individual stocks are typically described as small, mid, or large cap, depending on their market capitalization. Further classifications include micro, nano, and mega-cap, but far fewer companies qualify for these categories.

This article will focus on small-cap stocks and their role in the marketplace. Keep reading to learn about the key features of small-cap stocks and finding the right fit for them in your portfolio.

Investing in Small Cap Stocks.

What Are Small-Cap Stocks?

Small-cap stocks have a market capitalization between $300 million and $2 billion. Although generally accepted, this range can vary depending on the brokerage firm.

The famous Russell 2000 Index tracks the performance of approximately 2,000 small-caps. As of August 2020, companies in the index had a median market cap of $666 million. This index is the benchmark for the small-cap industry.

Two reasons why small cap stocks are considered “small:”

  • #1 The corporation has already maximized its growth potential. For lack of a better word, the stock is cap’d out! Growth opportunities are limited unless the business decides to enter into a new marketplace or acquire competitors.
  • #2 The corporation is in its early stages of growth. The stock has room to run! Small-cap stocks are generally more volatile and large institutions usually leave them alone because their shares have low liquidity. This results in small caps having less access to cheap capital from big banks, making them more vulnerable in economic downturns.

Small-Cap Stock Features:

While this time it’s different, we can explore the theoretical behavior of small caps in different economic environments. Readers beware, correlation does not imply causation!

  • Small-caps do better than large-caps when the Fed cuts interest rates
  • Stock Performance is domestically driven
  • Small-caps don’t react to geopolitical news like large-caps do
  • Small-caps out run the broad market in the early days of a bull-market

Examples of Small-Cap Stocks

While there are literally thousands of small-cap stocks that trade on the U.S. Stock market, here are a few examples we pulled for you.

  • Stag Industrial
  • Howard Hughes
  • Groupon
  • Office Depot
  • Bed Bath & Beyond
  • Tootsie Roll Industries (ticker: TR)
  • Denny’s Corp (ticker: DENN)
  • Abercrombie & Fitch (ticker: ANF)
  • Office Depot (ticker: ODP)
  • GameStop (ticker: GME)

Are Small-Cap Stocks Risky?

Small-caps are considered risky because of their volatility, specifically the kind of volatility that goes in the wrong direction. They have a higher chance of failing than their large-cap counterparts.

This is because it’s easier for a $300 million corporation with limited access to emergency capital to go to zero than a $10 billion company with unlimited resources.

While some investors do not have the appetite for this volatility, others crave it and rush to profit from price swings. This gives traders the opportunity to outperform institutional investors in the short-term.

Another risk of small-caps is they tend to receive less coverage than large-caps. Less available information on their fundamentals may result in investors making decisions when they don’t have the entire picture.

Read more on the differences between small and large cap stocks and how to capitalize on them.

Are Small-Cap Stocks a Good Investment?

The traits of small caps should not be considered entirely “good” or entirely “bad.” As we’ve now discussed their volatility at length, they still have a place in your portfolio.

If you don’t have exposure to small-caps, you will miss out on some historic bull-markets that may leave you kicking yourself.

For example, from 1999-2013, the small-cap index “Russell 2000” rose 114% in relation to the S&P 500!

Learn More: How to Invest in the S&P 500

How to Invest in Small-Cap Stocks (The Roadmap to Success)

#1 Choose a Stock Broker:

We like Robinhood because it’s easy to sign up and start investing right away! Read our review and check out how to make money on Robinhood.

If Robinhood isn’t for you, there are plenty of other brokers out there, such as M1 Finance, Stash, and Acorns.

Here is our selection of the best online stock brokers. We did the research for you.

#2 Fund Your Account

Simply connect your bank account and deposit the amount of cash you want to put to work.

#3 Purchase Small-Cap Stocks

You can purchase an index fund that tracks the performance of the best 2000 small-caps by investing in the Russell 2000.

If you think you can outperform the benchmark, then be sure to conduct your due diligence. We will cover the best places to research small-caps in the next section.

How to Research Small-Cap Stocks

Unfortunately, finding detailed information about small-cap stocks can be difficult for investors. However, there a few resources you can turn to for candid coverage.

Motley Fool

The Motley Fool offers free and paid content to help its readers achieve financial freedom.

The Motley Fool several famous market calls, such as Netflix in 2007 and Tesla in 2012.

If you were reading the Motley Fool in those days, you’d be up 20,347% and 8,910% on the investments, respectively.

Learn More: Motley Fool Review

Tradingview

Tradingview is one of the best stock charting websites available. Its free “Basic” plan offers more than enough tools to keep you informed on your favorite small-cap stocks. Also, the site lets you interact with other investors to identify trends before the happen!

Barron’s

Barron’s magazine is one of the most respected sources of financial information in history.

While Barron’s is behind a paywall, the subscription is well worth the price.

You’ll get inside the mind of world-class investors and access to invaluable information.

We are fans of Barron’s confidence as they are not shy to recommend stocks to buy and stocks to stay away from.

Learn More: Top Financial Magazines

Yahoo Finance

Yahoo! Finance offers a suite of financial resources to keep you informed up to the very minute.

We consider them one of the best sources of real-time quotes.

Additionally, Yahoo! Finance allows you to explore +100 technical indicators to ensure it’s the right small-cap stock for you!

Small-Cap Stocks and Asset Allocation

Your allocation to small cap stocks is ultimately determined by your risk tolerance and time horizon.

A risk-averse person may allocate 10% of their portfolio to small-caps while a risk-seeking investor may opt for 20%. It’s important to understand the tradeoffs to each of these strategies.

Remember, dollar-cost averaging is the one of the safest and most effective investing strategies.

Small-Cap ETFs to Consider

When investing in small-cap stocks it is best to invest in ETF. An ETF will give you exposure to hundreds of small-cap stocks all at once. You do not have to tie all of your capital to one sole stock.

  • Benchmark: iShares Russell 2000 Growth ETF (NYSE: IWO). Expense Ratio: 0.24
  • Conservative: Invesco S&P Small-cap Low Volatility ETF (NYSE: XSLV). Expense Ratio: 0.25
  • Average Risk: Schwab US Small-Cap ETF (NYSE: SCHA). Expense Ratio: 0.40
  • Value: Vanguard Small-Cap Value Index Fund ETF (NYSE: VBR). Expense Ratio: 0.07
  • Higher Growth: iShares Morningstar Small-Cap Growth ETF (NYSE: JKK). Expense Ratio: 0.30

Why Should You Invest In Small-Cap Stocks?

Any investor worth their salt knows the importance of diversification. Can you afford to have no exposure to small-cap stocks? If yes, then move on and don’t invest in them. It’s your capital and you’re free to invest it as you please.

However, you should have at least some exposure to small-caps if you value diversification.

Bottom Line: Small-Cap Stocks

We hope this article improved your understanding of small-cap stocks and how you can use them in your investment strategy.

Leveraging their pros and cons can yield significant gains in the market if traded the right way. Enough reading open an account and start investing in small-caps today.

More Investing Resources:

Sean Graytok
Sean Graytok
Sean is a lifelong student of the financial, media, and marketing industries. He is a Generation Z investing expert and is on a mission to empower investors to make the most of their money.