In talking about asset allocation, often individuals will recommend putting money into different classes of assets. For example, splitting money between “large caps” and “small caps” is usually recommended. Today I will go into what large and small caps are and why it is recommended that individuals split money between them.
Large Caps are stocks that have large capitalizations, the capitalization being the amount at which the company is valued. The capitalization is found by multiplying the number of shares outstanding by the price per share. The price per share is normally a function of earnings, with most stocks being priced somewhere between 10 and 30 times earnings per share. Obviously then, large cap stocks have large earnings (or at the very least, the potential to make large earnings when times are good).
Large caps are therefore large, well established companies. They will often have offices and/or stores in many states and have several different products. They are also likely to pay a dividend, having already grown enough to be able to give some of the money they earn back to shareholders. They also tend to have established product lines that provide predictable revenue streams. For these reasons, large cap stocks tend to fluctuate less in price than smaller companies.
Small caps are much smaller companies that are just getting started in business (or have been in business for a long time but have not yet “hit it big”). They tend to be opening more stores, gaining market share, and expanding. They typically need all of the cash they can get for meeting expenses and expanding, and therefore rarely pay a dividend. Really small companies are called “micro caps.” Companies between small and large caps are called “mid caps.” Because small companies have less predictable earnings they tend to fluctuate in price more rapidly. They are also more risky since a small company is less able to remain in business if it has a bad quarter or year than a larger company. They may also still be trying to find their niche in the marketplace and may never find it.
Because of the difference in risk, larger companies over the long-term will provide a lower return than small companies. This is for two reasons. The first is that because stock price is tied to earnings, and it is easier for smaller companies to double, triple, or quadruple earnings, the price of small companies is more likely to double, triple, or quadruple over time. The second reason is that because the smaller companies are more risky, the market tends to assign a larger “risk premium.” People will not be willing to buy the shares unless they are priced low enough that the potential increase in price in the future is enough to justify the investment.
So, one buys large caps for the more steady earnings and price and higher yields. One buys small caps for the prospect of higher returns and rapid earnings growth. During different periods of time one class will outperform the other, depending on whether the market is looking for rapid return or safer growth. In truly bad times, many fo the small caps will also be failing, so a portion of the portfolio in large caps will help preserve capital. In developing a portfolio, a mix of both, with a bias towards smaller issues for individuals with a larger time horizon is advisable.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.