Should You Invest in Small-Cap Stocks?

did you know that S&P 500Is an index of America’s 500 most recognizable and dominant companies, and has averaged 10% annual returns over its lifetime? Nothing to sneeze at, but Wall Street’s biggest and worst of companies don’t generate higher returns?

The average market capitalization of the S&P 500 stocks is about $60 billion, but when the industry’s top companies reach this level, it’s difficult to grow enough to continue to scale. Sure, we do get mega-cap stocks (valued at over $200 billion) from time to time, but only a handful of stocks reach that milestone.

you have to find next big thing If you are looking for even greater return on investment. Consider looking at small-cap stocks worth $300 million to $2 billion. Here are some reasons to improve portfolio returns and how to decide if they’re right for you.

Seeking big returns in small-cap stocks

Most companies in the S&P 500, and large caps in general, are already on top of the mountain. They typically have a strong position as leaders in their industry, generate a lot of profits, buy back shares, or pay dividends. You may have heard of these types of stocks called blue chip stocks. Small caps, on the other hand, are typically young companies that have just gained momentum. They are growing sales rapidly and may not yet be profitable.

For investors, calculating significant returns generally favors smaller stocks. please think about it. Is it easier for a mature company with a $100 billion market cap to grow to $200 billion, or a small, fast-growing $500 million company to grow to $2 billion? As you get older, math starts working against your company. Huge numbers usually don’t grow that fast, making it very difficult to move the needle.

But if it were that simple, everyone would invest in small caps. Actually, there is no free lunch. There are some important trade-offs investors should keep in mind before adding small caps to their investment strategy.

they are not for everyone

First of all, small-cap stocks tend to be much more volatile than large-cap stocks. less than, Russell 2000The leading index for small-cap stocks typically loses more than the S&P 500.

^RUT data by YCharts

Some small caps are down as much as 50% to 90% in the current bear market! Investors can safely get away when things get tough. Small-cap stocks typically have a poor track record, are unfollowed by analysts, and are often unprofitable. It’s easy to underestimate the difficulty of owning small-cap stocks in a bear market, so you should be comfortable with the risks and volatility that come with it.

Additionally, these up-and-coming companies are more vulnerable. Most companies lack a clear competitive advantage and require a truly superior product or service and strong management to sustain rapid growth. Difficult access to funds can be unprofitable and recession-prone. Ultimately, more stocks go under fire than they succeed long enough to become large-cap stocks.

A successful small-cap strategy

Small-cap stocks can generate significant returns, but some guidelines should be considered to avoid taking too much risk.

1. Insert your work.

Note that most small-cap stocks don’t get the constant analyst coverage that blue chip stocks do. The company’s strengths and weaknesses may not be obvious, so you should be prepared to roll up your sleeves and learn about the inside and outside of the company. If you’re not comfortable with individual stocks, you can invest in small-cap index funds such as: iShares Russell 2000 Growth ETF.

2. Diversify.

Even if you study companies more than anyone else, you can’t make every idea a success. Peter Lynch once said: “In this industry, if you’re good, you’ll be right 1/10 six times. You’ll never be right 9/10.” . Spread your investment and let the winners make the money.

3. Move slowly.

Small caps can be very volatile, so don’t buy your intended position size all at once. Dollar cost averaging can help here. If you’re buying slowly over time, you’re more likely to have a solid cost base. Small-cap stocks typically have a long-term upward trend, so you don’t have to guess which price is the bottom. It’s needlessly dangerous and usually backfires.

Justin Pope does not have a position in any of the stocks mentioned.The Motley Fool does not have a position in any of the stocks mentioned. The Motley Fool’s U.S. headquarters has a disclosure policy.

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