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Small Cap Stocks: Choosing Risk For High Rewards

Small cap stocks fail, but they have much room to grow.

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I have previously brought up blue chip stocks, very low risk stocks. In this post I will bring up small cap stocks, the complete opposite. Small cap stocks are a mostly forgotten form of investing in which deserves some consideration. To be clear though, I am not talking about penny stocks, which I will bring up another time.

What Are Small Cap Stocks?

Small cap stocks are equity shares of companies with a market cap between $300 million and $2 billion (usually higher than penny stocks). These are companies that have not grown as much. Many large-cap companies have started out this way and every small cap company can grow to become like them. There are many advantages and disadvantages to investing in small cap stocks.

Advantages

Small cap companies have higher potential to grow since they are starting closer at the bottom. But surprisingly, small cap company performances can be similar to those of large cap companies.

There is one particular advantage with investing with small cap stocks. Many mutual funds do not invest in small cap companies. The SEC’s regulations requires disclosures of financial health and investment policies. Some small companies cannot or will not fully disclose this information and mutual funds do not invest very much in them. This allows investors with high risk tolerances to invest in young companies close to their base level and allows the performance of small cap companies to be more separate from the global market indexes. This allows for diversification beyond what is found in a typical mutual fund.

Disadvantages

The obvious disadvantages to investing in small cap companies is the risk. Generally, small cap companies are more volatile than large cap companies so they are more likely to take severe fall downs. Large cap companies, especially blue chips are considered “too big to fail” but small caps are more likely to fail so note that individual companies can become worth zero far more suddenly than large caps. Due to the volatility of small cap companies they will be harder to sell at fair prices.

In addition to higher risks, timing is everything when you invest in small cap companies. Buying low and selling high is a bit more important for shorter term investing and for individual investments. But waiting too long could make you miss out on small cap companies that just exploded in growth.

Small Cap Stocks Are Good Investments

Small cap stocks may be more volatile, but they could add potential growth over the longer term. There are higher relative returns for investments in small cap indexes such as the S&P 600 or the Russell 2000. Investing in small cap companies can boost long term returns that would normally be seen by investing the S&P 500.

What I Recommend

I am not currently invested in any small cap company right now, unless you count Forge Your Wealth, which I promise you is worth less than $300 million as of this moment. I do plan to invest in small cap companies in the near future. However, I do not have the combination of free cash nor risk tolerance to try right now. The free cash I have available considering I will be moving very soon and intending to purchase a new(er) car I do not have enough free cash to start an investment that would require this high of a risk tolerance, yet.

That being said, there is also the potential that investing in small cap stocks right before a recession is not the best idea in the world. But recessions only happen when investors start becoming fearful and pull back from investing and there is always the possibility that a recession is no where close in the future. Being fearful of the future should not be a reason to keep you from investing, but it should make you more cautious. If you want to invest in small cap companies, you must know the ins and outs of the companies.

Index Funds

There are other potential options. For instance, I plan to invest in a small cap index fund in the future, which I highly recommend to do in the case of small cap mutual funds. The reason for this is because of the low expenses. The small cap stocks will be very volatile which means anyone invested in them will likely experience a roller coaster of emotions.

I know my risk tolerance. But I also know that if I invest in something as risky as small cap companies, I would want to make sure the expenses and fees are low. It is one thing to experience the swings of small cap companies. It is another thing to experience these swings while knowing you have to pay a good percentage in fees and expenses to experience those swings. I do not think that I could take negative swings like that over more than one year while also paying someone else money to maintain a high risk investment like that without having more control over it like I would with my own business. Index funds have expenses and fees that are less than 0.1%, with other mutual funds you would be lucky if the expenses and fees are less than 1%.

If you can deal with those expenses along with a bad few years without trading then it would be worth the investment. If not, small cap funds would not be worth it.

Do Not Invest Everything Into Small Cap Stocks

I know it sounds like I am praising small cap investments as the forgotten yet undervalued investment, but there is a reason they are not too popular. Small cap investments are very volatile and can fall at a moment’s notice. Any portfolio built of small cap investments alone may grow fast, but anything that ignites the volatility will make the assets untenable. Imagine having your portfolio make a plunge of 80% just before retirement. You will not be able to withdraw money from you assets without taking losses. I am pretty sure there are many stories of this happening to people before they retire.

Since small cap investments experience their best growth in the long term I would only recommend small cap investments in your retirement fund. I will never recommend having any more than 30% of your portfolio be in small caps. Then reallocate the stocks slowly over time so you have no small cap investments less than 10 years before your planned retirement.

Final Thoughts

Small cap stocks are hands down one of the riskiest investments known. On top of that, you will have little capability in controlling the companies you invested in. There are many other investments like businesses and real estate which have those high risks but more control, but they are not passive investments. Small cap stocks offer up a high reward investment with the same passive investing as any other stock, but at the cost of high risk.

Small cap companies may be worth investing in, but it is key to make sure you either diversify, or know the ins and outs of the company. If you are going the diversified path then you should try to treat it as a long-term investment, I recommend putting them in a retirement fund. If you are buying individual small cap companies, which I do not believe I will do, you must be attentive and knowledgeable and maybe even willing to trade. I do not advise in stock trading. I recommend only investing in a company if you see them growing in ten years. When invested properly, small cap stock investments are a good boost in assets that can forge your wealth.

Author: Papa Foxtrot

Most of my life I was careful with money and learned where I should invest it. I was very lucky to have parents who taught me financial literacy when I was young. Unfortunately, I am very lucky because many people lack the financial literacy I know. The purpose of Forge Your Wealth is to teach people who are just starting out in life how to obtain their wealth or anyone who just realized they may need to learn more to handle their finances. I currently have a PhD in biochemistry, just started a job in industry (will not disclose where exactly for personal and professional reasons) and am currently married to the love of my life. I am one of the lucky few people in America who graduated with no student debts, my wife was not. Over the series of a little over 3 years we paid for our wedding with no debt and paid off her federal student loans.

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