Large-Cap vs. Small-Cap Stocks: What’s Your Risk Appetite?

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Updated on Wednesday, February 26, 2020

Investing professionals use the terms large-cap stock and small-cap stock to refer to larger and smaller companies. The “cap” in both terms refers to market capitalization, or the total market value of a firm’s shares.

Market capitalization is calculated by multiplying the number of a firm’s shares by the price of the shares. When comparing small-cap and large-cap stocks, it’s important to understand that they differ on more than just size or market cap — they also offer different levels of risks and returns.

What are small-cap stocks?

Small-cap stocks are generally considered to be shares of companies with a market capitalization between $300 million and $2 billion. Strict definitions aside, some people stretch that range to include companies with larger market capitalizations.

“Some will say, ‘We consider anything up to $5 billion to be a small cap,’” said Kashif Ahmed, a certified financial planner in Bedford, Mass. “But most people will tell you it’s generally $2 billion or less.”

Many small-cap stocks are penny stocks, meaning their shares are priced under $5. These smaller companies ostensibly have more room to grow, giving shareholders the opportunity to realize substantial gains on these investments. Conversely, they can lose value very quickly, and small-cap stock volatility reflects this dichotomy. As a result, small-cap penny stocks are considered highly risky investments.

When he’s trying to explain small-cap stocks to a client, certified financial planner Michael Yoder will often show them a list of the top 25 holdings in a small-cap index and ask them how many names they recognize. “The two that get recognized the most are DocuSign and Fair Isaac,” said Yoder, who works in Walnut Creek, Calif.

Small-cap stocks are more volatile

Since small-cap stocks are shares of smaller companies, their stock prices tend to swing more widely. The Russell 2000 — an index that tracks 2,000 small-cap stocks — has proven to be significantly more volatile than the S&P 500, which tracks 500 large-cap companies.

“Over the last 10 years, small caps have been 42% riskier,” Yoder said. “To be specific, ETFs that track the Russell 2000 index have been 42% more volatile over the past 10 years than ETFs that track the S&P 500.”

Although small caps are a chancier venture, there’s also the potential for great performance. Small caps have historically outperformed large-cap stocks. There’s greater room for growth and opportunities to get in on the ground floor, so to speak, at a company that soars in later years.

And not all small-cap companies are startup companies taking risky bets. A small-cap company could just as easily be a company that makes light bulbs. “And everybody needs to buy light bulbs,” Ahmed said.

Small-cap stock features

  • Market capitalization of $300 million to $2 billion
  • Stocks are more volatile
  • Outperform large-cap stocks over the long term
  • Tend toward more aggressive growth strategies
  • Smaller percentage of them pay dividends

What are large-cap stocks?

Most people define large-cap stocks as shares of companies with a market capitalization of $10 billion or more. Large-cap stocks are shares of companies you’ve probably heard of: Apple, Exxon, Google and Coca-Cola are all large-cap companies.

Are large-cap stocks high-risk? Not generally. These companies tend to be established and well-known, although they’re not all decades-old behemoths. “Tesla is a relatively new company, but it has a gigantic market capitalization,” Ahmed said. “Whereas Ford and General Motors and Chrysler have been around forever, and their market cap combined is less than Tesla’s.”

Large-cap stocks: Less volatility, lower growth potential

Although they’re less volatile, large-cap companies are typically slower-growing. Consider that of the biggest companies at the beginning of 2000, only three out of 10 have grown, seven of the 10 are smaller and only Microsoft is still in the top 10.

“People see these big companies as unsinkable ships,” Yoder said. “Twenty years ago, people would’ve said, ‘What could possibly happen to General Electric?’ Now it’s a quarter of the size it was two decades ago.”

So while you may think that putting all your money in today’s large-cap companies is a solid investing strategy, it could backfire. “Trees don’t grow to the sky,” Yoder said. “The reason small caps sometimes outperform is they simply have more room to grow.”

Large-cap stocks pay dividends

There is one thing large-cap companies have over small-cap companies: payment of dividends. While fewer than four in 10 small-cap companies pay dividends, large-cap companies are often established enough to pay dividends out of revenues.

“Large companies that pay dividends tend to do better and are less volatile in times that there’s a lot of volatility because of geopolitical things that may be happening,” said Ron Palastro, a certified financial planner in Brooklyn, N.Y. “That would be another thing to take into consideration.”

Large-cap stock features

  • Market capitalization of $10 billion or more
  • Tend to be established, well-known companies
  • Stocks are less volatile
  • Growth tends to be slower overall
  • More likely to pay dividends than small-cap stocks

Large-cap vs. small-cap stocks: What’s the difference?

The primary difference between large-cap and small-cap stocks is size: Large-cap stocks are shares of companies with a large market capitalization, and small-cap stocks are shares of companies with a small market capitalization. Note that there are also mid-cap stocks with a market capitalization in the middle.

But there are also differences when it comes to company growth, volatility and other factors. Here’s how it breaks down:

 

Small-cap stocks

Large-cap stocks

Market capitalization

$300 million to $2 billion

$10 billion or more

Company age

Typically younger

More established

Growth

Often pursuing aggressive growth

Tend to grow more slowly

Risk

Higher-risk investment with higher volatility

Lower-risk investment with lower volatility

Dividends

Less likely to offer dividends

More likely to offer dividends

Small-cap vs. large-cap: Historical stock performance

In general, small-cap stocks are considered riskier and large-cap stocks are considered safer investments. But their performances over time depend on when you’re measuring. Over the long haul, for instance, small caps have historically produced greater returns. Since the stock market’s inception, small stocks have beaten large stocks by 4% annually, on average.

As mentioned, small-cap performance can be volatile in the short term. In the year ending December 2018, a small-cap portfolio would have lost more than 11%, compared to a large-cap portfolio’s 4.76% loss. Over the previous 20 years, however, small-cap versus large-cap returned 8.91% versus 5.97%, respectively. And since 1926, a small-cap portfolio would have returned 11.65% to a large-cap portfolio’s 9.83%.

That doesn’t mean large-cap stocks can’t deliver. “Over the last 10 years, large-cap stocks have rather significantly outperformed small caps, by a pretty wide margin,” Yoder said. “And from 1984 to 1999, large caps beat small caps by an average of 5% a year.”

Here’s how the Russell 2000 and the S&P 500 have compared since 1979:

Large-cap vs. small-cap stocks: How much risk do you want?

Investing in large-cap versus small-cap stocks depends somewhat on your appetite for risk and your time horizon. Small-cap stocks are a riskier investment, but if you’ve got decades until retirement, you’ve got time to weather some market swings.

“Someone who’s 25 can potentially take on more risk because if they lose more money, they have time to recover from that,” Ahmed said. “But at the same time, not every 25-year-old is wired the same. I have 25-year-olds who are very risk-averse.”

To invest aggressively in small-cap stocks, you must be comfortable with market swings, and you probably don’t want to put a large chunk of your portfolio at risk. “No matter how risky people think they are, they’re actually not,” Ahmed said. “The first time they see parentheses on their statement, they all change their religion very quickly.”

How much of my portfolio should be small-cap?

Planners suggest putting about 5% to 15% of your portfolio toward small-cap stocks. “You need exposure, but you need a little exposure,” Palastro said. “Maybe it’s 5% or 10%, but it’s not 50%. That’s how I try to explain it.”

On the other hand, leaning too heavily on large-cap stocks can also put you in a precarious position. “Most people consider large caps to be safer, which is often true,” Yoder said. “But in the last two recessions, small caps actually held up better than large caps.”

In other words, people with a portfolio full of mostly large-cap stocks lost more money than those with some small caps mixed in, even though it’s the riskier choice.

“Modern portfolio theory says that even if you add a risky asset to an overall portfolio, as long as it doesn’t move in lockstep with everything else in your portfolio, it can decrease overall risk,” Yoder said. “Even our retired clients still have a percentage of their U.S. portfolio invested in small-cap stocks.”

In the end, it’s crucial to have a mix of both small-cap and large-cap in your portfolio — along with a diverse mix of other investments. For best results, experts recommend a foundation of large-cap stocks (perhaps 30% to 40%) along with a mix of small- and mid-cap stocks, international stocks and some bonds.

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