Small Cap Stocks - Are The Rewards Worth The Risks?
For anyone that remembers the old days of television cartoons, the image flashed through your mind when you read the title. Wile E. Coyote is running along, looking for his supper, when he is blown off the road by the speedy Road Runner. It is hard to imagine turning that analogy into a discussion of the stock market, but that’s exactly what we are going to do.
Small-capitalization companies, also known as small-cap stocks, are the stock market's version of the Road Runner. While there are small-cap stocks that are in stock sectors that make them slower than large-caps, these companies generally are the ones that usually make Wall Street news for their explosive earnings that create double-digit returns for their investors.
Where are the little guys and are they big spenders?
There are several market indexes that track small-cap stocks, most notably the Russell 2000 and the Standard & Poor’s 600. While you can search for small-cap stocks on these indexes, the general rule is that a company is considered a small-cap stock if its market value is below $1 billion.
As a rule, small-cap stocks represent companies with similarly small revenues. Typically these are companies that are just starting out or they are in a position to expand their markets. For example, in 2004 the hamburger restaurant Red Robin experienced a 100% increase in both its stock price and its market value, the latter climbing to $780 million. Because it was small, the company was able to grow much faster than its large-cap cousin, McDonalds, which “only” saw a 27% increase. It remains to be seen what Red Robin will do in the future, but performance like their 2004 results would be an incredible asset to your stock portfolio.
Are small-cap stocks worth the pain?
Now we will have a quick stock market lesson; one of the basic stock investing concepts is that where there is great reward, there will likely be great risk accompanying it. This is true of small-cap stocks. The companies can rapidly climb the ladder of success but they can also fall off of it and take the investor with them. Small-cap stocks experience much more stock volatility than their large-cap cousins and because of this, they are far more risky.
In addition, small-cap stocks tend to suffer more during economic hard times than large or mid-caps because as investors sense a downturn in the market, they tend to rely on the blue-chips, or large-caps, to weather the difficult times. This alone makes them less appealing to those who are long term investing.
And now for the good news!
There is a positive spin to the risk of small-cap stocks. Unless you are only looking for long-term investments, small-caps can be a valuable part of your portfolio diversification. While you should follow your trading plan and use a stock trading system like Japanese Candlesticks, if you add small-cap stocks as one portion of your portfolio, you can enjoy their rapid growth and profitability without losing everything on one bad investment.
In addition, young investors who have time to be more aggressive with their savings should find small-cap stocks to be an excellent way to increase the value of their portfolio. It is still important to emphasize the need for fundamental and technical analysis even in the early days of investing. Why lose a small fortune in the beginning when you don’t need to do it? With due diligence, everyone can benefit from out-running Wiley Coyote with small-cap stocks!