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Putting on the Right Market Cap: Why Stock Size Matters
While there have been many times in history when the U.S. stock market's performance was driven in large part by the successes of large companies, there have been other times when the innovation and high-growth orientation of smaller or midsized firms led the charge during an economic boom. This raises an important question for investors — What role should a company's size play when assembling a long-term equity portfolio?
Defining Market Cap
Market capitalization, or market cap, refers to a company's value. How is market cap determined? By multiplying a stock's current share price by the total number of its shares. For example, if a company has issued 20 million shares that are priced at $20 each, its market cap would be $400 million.
Companies are generally categorized as small-cap, mid-cap, or large-cap. There are also micro-cap stocks — the smallest of the small. The definition of each category can vary, but typically, small caps have market values of $3 billion or less, mid caps have values of $3 billion to $10 billion, and large caps have values of more than $10 billion.*
As you may have guessed, a company's market cap is related to its growth pattern. A good analogy may be family siblings: Small-cap firms are often younger and may be growing at a fast rate; mid-caps (like the middle child) may be experiencing — or expected to experience — rapid growth spurts; and the often older, more mature large-caps might still be growing, but at a slower rate.
Sizing Up Company Size
When it comes to investing, a company's size is an important consideration. Small-cap stocks may offer substantial growth potential due to filling niches in the market, but they may also be subject to higher levels of volatility than other stocks. Add in the above-average rate of small business failures and you're looking at increased investment risk. Even still, small caps can be broken down into several sub categories (e.g., growth or value) and each has historically performed differently and had varying levels of risk.
Similar to small-cap stocks, mid-cap stocks may have the potential to grow quickly. On the risk spectrum, they generally fall somewhere between small caps and large caps. This is an important stage for a company and often determines whether it will become a leader in its field.
Large caps are generally mature companies that are dominant within their industries or markets. They are generally considered less of an investment risk than smaller companies over the long term.
Capitalization and Your Portfolio
So, what does a company's size have to do with investing? A lot, actually. Just as fashion styles change, market caps take turns "leading the pack" during different periods of time. While past performance cannot guarantee future results, maintaining a mix of market caps in your equity portfolio may potentially help reduce risk and enhance returns.
Make sure that the market caps your portfolio "wears" are ones that fit your goals, time horizon, and risk tolerance. A qualified financial consultant can help with an equity portfolio review.
*Source: Standard & Poor's.
© 2010 Standard & Poor's Financial Communications. All rights reserved.