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There are a lot of different asset classes when investing.
A popular class is small cap stocks.
Historically, small cap stocks outperform large cap stocks, which makes them a favorite of many investors.
But before you jump head first into the world of small cap investments, you need to know the risks.
In this post, I share with you the biggest pros and cons of small cap stocks you need to know.
Table of Contents
10 Critical Pros And Cons Of Small Cap Stocks
5 Pros Of Small Cap Stocks
Here are the biggest advantages of investing in small cap stocks.
#1. Higher Potential Long Term Gain
Most small cap companies are newer, younger companies, and because of this, they tend to produce above average returns.
As they earn money and reinvest it into their product line, equipment, and workforce, they grow quickly.
Because they are growing so quickly, their share price has to keep up, which leads to a higher growth potential over the long term.
This higher growth potential translates into the possibility of higher returns every year.
#2. Small Cap Stocks Outperform Large Cap Stocks
As I mentioned at the beginning of this post, historically, small cap stocks easily outperform large cap companies.
One study shows this outperformance by 10%.
Think of this idea this way.
A small cap stock is like a toddler.
If you don’t see them for a few years, you are blown away at how big they have gotten.
Even if you do see them on a regular basis, you know that they can outgrow their clothing size within a year.
Adults on the other hand, are like large cap companies.
You don’t see a lot of growth.
This isn’t to say you shouldn’t be investing in large company stocks.
It’s just saying why small caps tend to outperform large caps over time.
#3. Double Money Quickly
It’s a lot easier to double your money quickly with a small cap stock.
Not only are the share prices traditionally lower, but the number of shares outstanding tends to be a lot less as well.
Because there is a small supply, if demand increases, the price of the stock becomes much more valuable.
And there are many reasons for the demand to increase.
The small cap company could develop a new product, get approval to bring a prototype to market, or even partner with a larger business, which will increase sales.
All of these are reasons why you could double your money or more over a short period of time.
#4. Small Cap Stocks Tend To Be Lower Priced
Small cap companies tend to have a low valuation.
They don’t have a lot of sales and as a result, the stock price is low along with the number of shares outstanding.
This allows investors to buy many shares.
If you have $1,000 to invest in Amazon stock, you are only buying 0.33 shares of stock.
But that same $1,000 could buy 500 or more shares of smaller companies.
#5. Invest In Index Funds
While many small caps have some downsides that you will see, the biggest way to get around one big potential loss is to invest in small cap index funds.
With index funds, you are buying a large group of a small cap stock.
- Read now: Find out the pros and cons of index funds
- Read now: Click here to see the important of diversification
This means if one company fails or underperforms, you don’t lose all your money.
You have it spread out among hundreds of companies.
This greatly reduces your risk in individual small cap stocks as an investor.
5 Cons Of Small Cap Stocks
While small cap investing does offer greater returns among other things, there are downsides you need to be aware of.
Here are the biggest drawbacks to small cap stocks.
#1. Greater Potential Loss
Studies show that by the fifth year in business, 50% fail.
If you have all your money tied up in one of these companies, you just lost everything.
And while it is great to think that you will just invest in small cap companies that will make it, knowing who these companies are is virtually impossible.
For example, back in the day, many believed Apple was going to go out of business.
If it wasn’t for the iPod, who knows if they would have made it.
Think back even to Amazon.
Who would have thought that Amazon would have become what it is today?
The fact of the matter is, hindsight is 20/20 and in the moment, you have no idea which small caps will survive or not.
This ultimately means you have much greater risk investing in companies with a small market capitalization.
#2. Hard To Find Analyst Research
Adding to the issue above is that is very difficult to find a lot of research on small cap stocks.
You might find there is no analyst that has done any research on a stock.
At this point, you are basically throwing a dart at a dartboard.
You have no idea if this company will make it or not.
And if you do find a small cap with an analyst, they might only be looking at the stock once a year.
As we all know, a lot can happen in a year, so their analysis of the stock being a good buy might not be the conclusion if more information came to light.
This adds to the higher risk that is already around small cap investing.
#3. Higher Volatility
Because these small caps don’t have a lot of shares available to trade, they can get very volatile when demand increases or decreases.
It is not uncommon for these penny stocks to double in price one day, only to lose half that value the next day.
And the same is true on the other end.
If bad news comes out, investors might fear this is something the company cannot overcome and will eventually close shop.
As a result, small cap investors want to get out no matter the price.
This can drive the price down 50% or more, only to have it come back a little in a few days time.
#4. Less Liquid
Overall, small cap stocks tend to be less liquid than large cap companies.
This is just another way of saying they are harder to sell.
They are not as hard to sell as a house or artwork, but depending on the stock, you might find you have to wait a day or two in order to find a buyer for your shares.
Or you might even have to compromise on the sale price you want to get.
#5. Potential For Manipulation
The final drawback of small cap stocks is they are easy to manipulate.
Because of a lack of analyst reports, some people can post fake news about the company and see the share price jump in value.
Or they can buy large quantities of shares, driving the price up.
Investors might see this jump in price and want to get in on the action.
This drives the price higher.
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Then the original investor sells their shares, making the stock price crater.
The result is wild swings in the price of the stock.
This effect is even more pronounced on penny stocks or stocks with a low share price.
When a penny stock is trading at $2 a share, you can buy a lot of shares if you have the cash.
And with not many shares to trade on the market, it is easy to move the share price a few pennies and make a lot of money.
There are the biggest pros and cons of small cap stocks.
While the drawbacks to this investment type sound scary, there is a place for small company stocks in most investors portfolios.
The key is finding the right allocation for you.
You don’t want to be so heavily invested that you suffer large losses as a result.
At the same time, you don’t want to stop investing, and miss the higher return these investments provide.
Take the time to find the right balance for you and your financial goals.
- Read now: Click here to determine your ideal asset allocation
- Read now: See sample model portfolios for you to invest in
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I have over 15 years experience in the financial services industry and 20 years investing in the stock market. I have both my undergrad and graduate degrees in Finance, and am FINRA Series 65 licensed and have a Certificate in Financial Planning.
Visit my About Me page to learn more about me and why I am your trusted personal finance expert.