Having a basic understanding of terms like "small cap" and "large cap" is key if you want to ensure your investments line up with your financial objectives.
For dentists and other investors, investments such as lifecycle funds and index funds have opened up a wide variety of investment vehicles that don’t necessarily demand a deep understanding of different terms and principles. But one idea you should familiarize yourself with is the different categories of securities you’re invested in.
If you take a close look at your investment returns, many funds you may be invested in will show a breakdown of your investment funds into different categories that may include “big cap,” “mid cap,” and “small cap” stocks. One might assume that big cap stocks are shares of larger companies, and so on. But while this is mostly true, it doesn’t necessarily correlate to the investment opportunity inherent in each. Having a basic understanding of the terms will help you measure your investment performance and ensure that your actual investments line up with your financial objectives.
“Cap” is simple short-hand for market capitalization, which is determined by multiplying the price of a stock by the number of shares outstanding. This is generally seen as the market’s estimate of the overall value of a company, though it should be noted that publicly traded bonds also impact this value.
These are the large publicly traded companies such as Apple, Microsoft, General Electric, Ford, and Google. Large-cap stocks are often considered “blue chip” stocks, and they are often seen as less risky than small- or mid-cap stocks. This is not always true. While large-cap stocks get much of the attention of the financial coverage, this isn’t because they outnumber small-cap stocks. In fact, the opposite is true. But the behemoths get most of the coverage, in part because their performance drives much of the lucrative investment banking business. Large caps typically have a market capitalization of $15 billion or more.
Small-cap stocks have often been seen as the little engine that could. Due to their low valuations, they are seen as offering potential to grow into big-cap stocks and are the subject of many an investor’s dream. Small caps tend to be less mature businesses that typically have market caps of less than $1 billion.
Mid-cap stocks are the ‘tweeners—those companies with a valuation between $15 billion and $1 billion. There are many companies in this range and a great deal of opportunity for investors. Many analysts and investors consider mid-cap stocks to be a “sweet spot” for long-term investors, because they are typically pretty well established companies that may not necessarily have the explosive growth potential of a small-cap stock, but also don’t bear the risk that those little guys inevitably bring. Yet, these companies may be on the precipice of entering into a period of explosive growth, and they are generally still adaptable enough to anticipate changes in business models and adapt to them. Picture Netflix in 2007, or Amazon in 2005—two companies that were well-established companies still innovative enough to change their revenue models substantially.
What It All Means
As we covered in a previous article on diversification, having a truly diversified investment portfolio means having investments across many investment vehicles and among many categories within each vehicle. Understanding the caps can help you make sure you have a good mix in your stock portfolio—one that balances risk and reward according to your goals.