Should you Buy Small Cap Stocks or Large Cap Stocks?

Stocks are generally divided into two groups, small caps and large caps.  (OK, there are mid caps too, but you get the idea.)  These designations stand for “small capitalization” and “large capitalization.”  Capitalization is the market value of the company — essentially what it would cost to buy the whole company — and is equal to the market price times the number of shares outstanding.

Among the more well-known large cap groups is the S&P500, which is essentially made up of the 500 biggest stocks in the market.   There is also the Dow Jones Industrials and the Dow Jones Transportation Index, which is made up of the most dominant company in each of several different business lines.  The best known small cap group is the Russell 2000, which is made up of 2000 small companies.  There are mutual funds that allow you to buy the stocks in each of these indices, so you can direct your money into large caps or small caps with a single investment tool.  You can also choose individual stocks in each of these sectors.

The question though is in which of these groups should you invest?  (Actually, the better question is what percentage of your account should you allocate to each sector, since you should hold both large and small caps in your portfolio.)  Well, large cap stocks tend to be safer since they are companies with several business lines and the financial resources to weather some downturns, as long as they are well run and don’t take on too much debt.  Large caps are therefore suited for investors who want more security and less fluctuations in the value of their accounts.  Large caps also tend to pay dividends, so they can provide an investor with income during times when the market is going nowhere.

On the other hand, small caps are small company stocks that have a lot of room to grow.  Over long periods of time, a basket of small caps will outperform a basket of large caps just because small caps can grow more than large caps can.  Understand that during that time there will be a lot more small cap stocks that fail than large cap stocks, but given enough of them grouped together the small cap stocks that survive and grow will more than make up for the ones that fail.

So, the choice between small cap and large cap stocks comes down to how long you have to invest and your personal tolerance for risk.  If you are in your 20’s and investing in your 401k account, you will not need the money for 40 years or more.  It would therefore make sense to invest more in a small cap fund than in a large cap fund.  As you age, you should shift money to large caps to help preserve the money you have made while still allowing your wealth to grow.  If you are in retirement and living on your portfolio, you should have a relatively small percentage of your assets in small caps since you don’t have the time to wait for the small companies to mature.  You need companies that are making a lot of income now and paying out a good portion of it in dividends.

Note that even when you are young it is generally not a good idea to be fully invested in just small caps.  Likewise, you should keep some small cap exposure when you are older.  The reason is that different areas of the market will do better at different times.  Early in a bull market, small caps will tend to outperform large caps.  Late in the bull  market, the large caps will outperform.  While over long periods of time the small caps will have a higher return, you never know which segment will do better over short periods of time, like five-year periods.  When you are young you might have 90% of your portfolio in stocks with a 60-30 split between small and large caps, for example.  When you are 50, it might be 60% stocks with a 20-40 split between small and large caps.

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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

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