There are two broad strategies in equity investing. One seeks long-term growth and increases in share price. The other seeks income in the form of dividends. Generally speaking, these strategies are also divided among stock and bond investors, where one is geared to the former and the other is geared to the latter.
A “small cap” stock is one where the company’s market capitalization is at a lower level than larger or older companies. The expectation with a small cap stock is that their innovative, high-energy business practices will lead to higher sales and a rapidly growing stock price.
Many investors consider different strategies for investing in small cap stocks.
Investors primarily interested in accumulating more shares at higher prices often use small cap issues. as the vehicle for a growth portfolio. This strategy is achieved by holding shares as long as possible while building positions in many small cap companies.
While this isn’t diversified investing per se, it is a method of diffusing risk among many companies while maintaining a high growth focus. Most small cap stocks reinvest their earnings, so investors rarely have the opportunity to purchase additional shares with dividends and interest. The counterbalance, however, is that small cap stocks often split, which allows investors to acquire new shares without investing new capital to obtain them.
Small cap stocks are generally more volatile than more established issues. While this adds risk, it also presents agile investors with the opportunity to purchase positions with varying cost bases. This is called dollar-cost averaging.
The average risk over a series of several purchases at different price points is often far lower than a single purchase at a single price point. Even if the stock drops precipitously, a cost-averaged risk occasionally preserves the value of some of an investor’s positions.
Managing a dollar-cost-averaged portfolio can be more time-consuming than simply accumulating shares in one or more issues. The rewards and risk avoidance, however, are worth it based on the experiences of most investors interested in small cap positions.
Funds and Sectors
Some investors prefer to spread their risk across many issues. These portfolios are often far more effective if they choose to purchase an index or a fund. Some funds offer focus on certain sectors like technology or finance. Others simply peg themselves to a popular small cap index.
The practical result of a fund-based approach is that performance can be gauged across the entire category as opposed to trying to follow the fortunes or analysis of a single issue. Fund and index-based investing also has built-in cost averaging and risk mitigation in the form of a more diversified portfolio with historical data to back projections.
Small cap stock investing can be rewarding, and for investors primarily concerned with growth, it is an essential part of any well-built portfolio. The key to overcoming the challenges with small cap stocks is to recognize that volatility isn’t automatically a disadvantage and to make certain true risks are mitigated with a strategy that avoids concentrating positions.