Novice investors or even those allocating their 401K, often come across the terms “small cap,” “mid cap,” and “large cap.” Common perception is that this refers to the size of the company. In a way that is correct, the term “cap” is short for market capitalization. For investing purposes, market capitalization is calculated by multiplying the number of outstanding shares by the current price per share.
Companies with a market capitalization above $10 Billion are considered “large cap.” Those with market capitalization between $2 Billion, but below $10 Billion are “mid cap” and those below $2 Billion are “small cap.”
The overall concept is very simple, but how does the information apply to your decisions. To cover this goes into portfolio diversification and allocation. Your portfolio is all of the investments, whether it is stocks, bonds, cash savings, gold, collectibles, etc. Diversification just means “don’t put all your eggs in one basket.” When building a portfolio it is crucial that your total investments be divided among differing investments. For instance you would not have wanted your entire portfolio invested the financial industry a few years ago. If you had, some of your investments would have likely disappeared as many firms went bankrupt. The process of determining which diverse investment mediums in which to invest your capital is called allocation.
Just as you would not want to be tied into one industry within your portfolio, you also want to allocate your resources into differing market capitalization. “Small Cap” companies are often newer companies who are growing. This growth offers investors tremendous potential for returns well in excess of the market average. The down side, as we know, is that potential often does not materialize so with the possibility of great reward one can expect great risk. It is for this reason that you also want “mid cap” and “large cap” investments in your portfolio to mitigate the potential risks of investing in smaller, unproven stocks or mutual funds.
By Jeremy R Woods
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