Are you curious about the average returns for large cap, mid cap, and small cap stocks? Let’s dive into market capitalization and how you can use it to diversify your investments effectively.
When you start investing, people often suggest that picking individual stocks is the best way to build wealth. However, stock picking requires a lot of time and effort to analyze stocks, or a substantial amount of money to be well-diversified.
For new investors, a well-diversified portfolio can be achieved by investing in low-cost index funds. These funds reduce the risk associated with stock market drops because they encompass an entire index rather than a few individual stocks.
Market capitalization, often referred to as “cap,” is a quick way to determine the size of a company. While a stock price alone doesn’t reveal much about a company’s total value, market capitalization is calculated by multiplying the stock price by the number of shares outstanding.
Here’s a breakdown of what constitutes small cap, mid cap, and large cap stocks:
– Mega cap: Companies with a market cap over $100 billion.
– Large cap: Companies with a market cap of $10 billion or more.
– Mid cap: Companies in their expansion phase, often ranging from $2 billion to $10 billion.
– Small cap: Companies with a market cap up to $2 billion.
Small cap stocks have fewer publicly traded shares, often giving individual investors an edge since institutional investors are less involved. However, they may lack liquidity and face challenges in attracting capital. Despite these risks, small cap stocks can offer higher rewards due to their potential for exponential growth.
Mid cap stocks have a higher trading volume and are generally more stable than small cap stocks. They can be small companies that are growing or mid-sized companies in profitable niches. There’s also more research and market data available for mid cap stocks, making them attractive for their growth potential and lower volatility.
Large cap stocks, with a market cap of $10 billion or more, are the least volatile during economic downturns and are generally more stable. They make up over 90% of traded stocks and include big names like Facebook, Apple, and Disney. These stocks are stable, transparent in their financials, and often pay dividends. However, their growth has typically slowed compared to smaller companies.
Why focus on company size? Historical data from 1972 to 2020 shows differences in performance and volatility among large cap, mid cap, and small cap stocks. Small and mid cap stocks have historically outperformed large cap stocks, although they come with higher volatility. Investing in smaller companies can be a great addition to your strategy if you’re focused on growth.
However, with higher returns come higher risks. It’s crucial to know your risk tolerance before investing in small or mid cap stocks. If you’re stressed about market fluctuations, these might not be the best options for you. Instead of basing your asset allocation on arbitrary factors like age, consider your risk appetite, time to retirement, and desire for international diversification.
For investors with a long-term horizon (25+ years) who can handle some volatility, adding small or mid cap stocks to your portfolio could be beneficial. One easy way to do this is through index funds or ETFs, which offer high diversification at low costs.
Historical data shows that small and mid cap stocks tend to outperform large cap stocks over the long term, although there have been periods where large cap stocks have led the way. Remember, this is historical data, and future performance can vary.
Only consider focusing on mid cap and small cap stocks if you’re comfortable with the additional volatility and are investing for the long term. Index funds make diversification simple and cost-effective.
What do you think about large cap vs. mid cap vs. small cap stocks?