What Makes Small-Cap Stocks Mighty (and Risky)

Small-cap stocks can bring diversification and higher growth potential — albeit with higher risks — to a portfolio. Here's what to know before investing.
Understanding Small-Cap Stocks

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Investors salivate over the biggest companies in the market — the likes of Apple, Google and Amazon — but where’s the love for the market’s perpetual underdogs: small-cap stocks?

When these investments do get some time in the limelight, it’s often for unflattering reasons — violent price swings or fraudulent activity, for example.

If you don’t currently have holdings in these stocks or related funds, it might be time to add some to your portfolio. Small caps can diversify portfolios and bring higher growth potential — albeit with higher risks. Here’s what you need to know.

What is a small-cap stock, exactly?

Small refers to, well, small; cap is shorthand for market capitalization, or the total number of a company’s shares multiplied by its current stock price. In other words, small-cap stocks come from companies with total market values that are still relatively modest.

The definition of small is subjective, however. The Russell 2000 Index, the first benchmark of small-cap stocks, is the best-known gauge. The market caps of its member companies currently range from about $240 million to $6 billion. The other major indexes tracking these stocks — the Standard & Poor’s SmallCap 600 and the MSCI USA Small Cap Index — include U.S. companies with even broader ranges of market caps.

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Why small-cap stocks are risky

As small-cap businesses expand, their stocks offer a higher growth potential compared with larger companies. But that comes with a greater risk of volatility — including more (and bigger) fluctuations in stock prices and earnings reports. This trade-off is known as the risk premium.

Small-cap stocks can also be more fertile territory for fraudulent activity.

Why small-cap stocks are mighty

The sheer number of small-cap stocks means there’s a plethora of options for investing in them. What’s more, the proliferation of exchange-traded funds has made it easier to buy a basket of stocks with a specific investing strategy — growth or value, for example. Small caps can be an underappreciated — or even overlooked — way to add diversification to your portfolio.

Small caps historically have a relatively high correlation — meaning they tend to move in lockstep — with large-cap stocks. But which group is performing better than the other over a given time frame fluctuates regularly, based on factors such as macroeconomic growth and politics.

Best small-cap stocks, ordered by one-year performance

Below is a table of the 10 Russell 2000 stocks with the highest one-year returns, in descending order.

Stock data may be delayed and is intended for informational purposes only.

Why small-cap stocks are not that different

It’s important to know what makes small-cap stocks distinctive, but you shouldn’t necessarily obsess over the differences. They have a lot in common with the others that might be in your portfolio: They trade on exchanges, their prices are published intraday, Wall Street analysts write research reports about them, and by virtue of being public, these companies must disclose a wealth of information to investors.

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