Small cap stocks are publicly traded equity interests in smaller companies, typically companies with $1 – $5 billion in market capitalization and less. Unlike most large cap stocks, which include household names such as IBM, Apple and Google, small cap stocks tend to be less well known to the public. As an asset class, they tend to have more risk and be more volatile than large cap stocks. This is mostly due to the fact that smaller firms have less access to capital and are less diversified in their operations than larger firms.
Historically small cap stocks have, generally speaking, outperformed their larger capitalization counterparts over the long run. This is due to the fact that small firms oftentimes have a smaller market share, and therefore have more room for growth than larger firms, who may have already captured a large share of the market in which they operate. As a result, smaller firms are oftentimes able to grow and expand their market share, revenues and earnings at a higher rate than larger firms.
Due to their relatively high volatility and risk, small cap stocks are best suited for investors with longer time horizons and higher risk tolerances. For the right investor, small cap stocks can play an important and valuable role in his or her overall asset allocation. By combining them with other asset classes such as domestic large cap stocks, international stocks and fixed income instruments, the portfolio can be tailored to the risk tolerance and time horizon of the investor.