Investing in small-cap stocks? Here are its pros and cons

Summary

• Small-cap companies have a higher potential to grow compared to large-cap firms, making them more attractive to investors.
• However, small-cap stocks carry relatively high risks due to their small size and volatile nature.
• Investors should carefully conduct their research before going ahead with a buy.

Small-cap stocks belong to companies with low market capitalisation or market value of the outstanding shares. Even as different stock exchanges have different rules to differentiate a company as a small cap, a company with a market capitalisation in the range of AU$50 – AU$500 million, is generally placed under this category. 

Since these stocks are associated with higher risks as compared to large-caps, investors with higher risk-taking capacity are generally seen to be interested in them. Buyers should be careful of the volatile nature of small caps while investing in them. Here, we will check out the advantages and disadvantages of small-caps:

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Advantages

High potential for growth

Small-cap companies have high potential to grow since these have a low total value compared to the large-cap firms. Today’s well-known large-cap firms were once the companies with low market capitalisation. An investor with right foresight to invest in small-cap firms could earn significant returns as the company grows. Large-cap companies generally have a limited growth potential.

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Small-cap value index funds

Individual small and undervalued firms generally have more chances to fail, as against large companies. However, investors can invest in them via value index funds, which are much safer. There is also a higher chance for investors to earn higher returns from these funds, but it requires experience and expertise to do so.

Disadvantages

Higher risk

As already discussed, small-cap stocks carry higher risk compared to large-cap stocks. Generally, the growth potential of a small-cap stock shapes its valuation. It is also a reality that not all small-cap companies can replicate the success of big established firms.

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More susceptible to volatility

Small caps see higher volatility in trading on account of their size. It takes lower volume to move prices.

A small-cap stock price generally swings 5% or more in a trading day. In addition, very few analyst reports cover such stocks. So, it is challenging to develop an informed opinion of the stock.

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