The "cap" in small cap stands for capital. Small-cap companies don't have as much cash and assets as large-cap companies. This makes them riskier because they're more prone to failure than established businesses. On the other hand, young, growing companies can succeed. When investors put money in these companies, they may succeed along with them. The higher risk may be worth the potentially higher rewards.
Room to Grow
A small company can double sales more quickly than a large company, according to Monevator (monevator.com). This is because large companies often have captured most of the market share they are going to capture. Small companies can dramatically improve sales by moving into new markets. For example, a small company may improve its sales by 35 percent, whereas an established company could consider five to 10 percent sales growth to be a reasonable goal. Growth in a company can translate to growth in its stock. The explosive growth for potential for small caps can make them attractive to investors.
Investors can find a small company in their neighborhood whose stock could be poised for large gains. Because small-cap stocks don't get researched as heavily as their large-cap counterparts, a savvy investor could be one of the first to find a potential winner. For example, a regional burger chain might have a restaurant in an investor's neighborhood. If the investor had a positive experience eating there, he might keep an eye on the restaurant as a small-cap possibility if the company goes public.
According to CNNMoney, small-cap stocks have outperformed large-cap stocks since 1926. CNNMoney also says small-cap stocks in America kept growing steadily throughout the European debt crisis while other stocks faltered. This out-performance factor can make small caps a profitable addition to a portfolio.
Investors take on more risk when they buy a small-cap stock. Few investors would risk an entire portfolio on small caps. However, if investors have some safer large caps, bonds, and mutual funds, they may consider putting a percentage of their money at higher risk to try to get higher returns. Small caps give them this opportunity. Investors can look at the risk of an entire portfolio rather than any single investment. For example, if an investor has 50 percent of a portfolio in Treasury bonds, that portion is backed by the credit of the United States. Putting a small percentage in risky small-cap stocks can make sense to investors who have other money in safe investments such as T bills.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.