Do you want to know the average return for large cap vs. mid cap vs. small cap stocks? Here’s what you need to know about market capitalization and how you can optimally use it to diversify your investments.
When we start investing, people try to convince us that we can best invest in individual stocks when we want to build wealth.
Stock picking can be for the people who are willing to spend time and effort learning how to analyze stocks. Or for the people who have enough money to be diversified.
When you’re starting as a new investor, investing in a well-diversified portfolio can be done by investing in low-cost index funds. With low-cost index funds, you have less to fear when it comes to stock market drops since you have an entire index instead of a couple of individual stocks.
What Are Large Cap, Mid Cap, & Small Cap Stocks?
When we talk about large ‘cap,’ the ‘cap’ part is short for market capitalization. It is a quick way to see how large a company is.
It is easy to see a stock price, but that doesn’t tell you much about the company’s total value. When calculating the market capitalization, you look at the stock price times the number of shares outstanding.
Here are the general guidelines on what value makes a company small cap, mid cap, or large cap:
- Small cap – market cap is less than $2 billion.
- Mid cap – market cap between $2 billion and $10 billion.
- Large cap – market cap bigger than $10 billion.
Some analysts also identify mega cap, which is companies with a bigger than $100 billion market cap.
Small Cap Stocks
Small cap stocks have a lower volume of publicly traded shares with a maximum $2 billion market cap. That means that institutional investors are often not involved in these shares, which gives the individual investor an advantage.
Small cap stocks may lack liquidity, which could mean it takes longer for orders to fulfill. Plus, it may be harder for them to attract capital.
However, with the higher risk comes a higher reward. Because these companies are so small, it’s easier for them to grow exponentially. They can adapt to changes fast and keep to their growth.
Mid Cap Stocks
Mid cap stocks have a higher trading volume than small cap stocks. They are in their expansion phase and are a bit more stable.
Companies in the mid cap range can be small cap companies that are growing or mid cap companies in some very profitable niches.
The upside is that there is research and market data you can access about mid cap stocks. Some of these mid cap stocks have great growth potential. Their lower volatility and their higher growth potential makes them great investments!
Large Cap Stocks
Large cap stocks have a higher trading volume and a market cap of $10 billion or more. These stocks are the least volatile during economic downturns and are generally more stable.
Since they are so big, over 90% of traded stocks concern large cap stocks. Big large cap stocks are Facebook, Apple, Disney, and many more.
Large cap stocks’ advantages are that they’re stable, transparent in their financials, and they can decide to pay out dividends over time. Because they’re so popular, there is a lot of market data and research available for review.
However, the downside is that they often are matured companies, and therefore their growth has slowed down. It can still set you up with a pretty good return, but is it the best company size to invest in?
Why Focus On Company Size?
Okay, so why is it so important to focus on company size? My personal curiosity was: will one of the stock types outperform the others historically?
That’s what we all want to know. Is there data to support that one type of stocks (large cap vs. mid cap vs. small cap) outperforms the others? Can we make more return investing in a certain type of stock?
I took a look at the historical data from 1972 to 2020.
Here are the annual returns for each stock type, plus inflation:
In the table, you can see that each type of stock is correlated with the others. In good years, all of them go up. Plus, in bad years, all of them go down.
However, there are differences in performance and volatility. Volatility is expressed in the standard deviation of the stock type. The more volatile a stock is, the higher the ups and the lower the downs.
When you look at the average annual return, you can see there is a difference in performance:
This means that, specifically from 1972 on, small- and mid cap companies outperformed small cap companies in terms of performance. Mid cap companies have less volatility than small cap companies, making them a more stable addition to your portfolio.
Why Consider Smaller Companies?
What is the reason you could focus on smaller companies when you can buy large cap stocks like Microsoft and Apple? Investing in small companies can become a great addition to your current investing strategy, where you focus on your portfolio’s growth.
While it is less popular than investing in big companies, we see that historically speaking, small- and mid cap companies provide a bigger investment return.
If you have a company with a market cap of $250 million, it’s easier for the stock to double compared to a company with a market cap of $250 billion.
Of course, we know that historical results and past performance are no guarantee of future results, but it’s fun to draw conclusions from them.
How To Choose Your Allocation?
Before you even start considering investing in small- or mid cap companies, know that with a higher return comes higher risk. We already saw that the volatility is higher for small- and mid cap companies than large cap companies.
Know what kind of risk you’re willing to take for these returns. It is not worth it if you are stressed out whether your investments will go up or down.
While many will advise you to base your asset allocation on arbitrary things like your age, in my opinion, this is outdated investment advice. There are more accurate measures on choosing your asset allocation, like your risk appetite, your time to retirement, and whether or not you want to diversify your assets internationally.
When you are an investor that can stomach some volatility and have a long-term horizon (25+ years), you could look into adding some small cap or mid cap stocks to your portfolio.
An easy way to add more small- and mid cap stocks to your portfolio could be to invest in index funds or ETFs. With index funds, you are highly diversified, and the costs of holding are generally low. Choose a mid cap index or a small cap index.
For example, you can look at:
- Vanguard Mid-Cap Index Fund (VIMSX)
- iShares Morningstar Mid-Cap Growth (JKH)
- Vanguard Small-Cap ETF (VB)
- SPDR S&P 600 Small Cap Growth ETF (SLYG)
This is no investment advice, I’m not a financial advisor, and these are just some suggestions you could do your own research on.
Final Words: Large Cap vs. Mid Cap Vs. Small Cap
Historical data shows that small cap and mid cap stocks outperform large cap stocks over the long term. There have been years where large cap stocks have been outperforming small cap and mid cap stocks, but not consistently.
It is important to say that this is historical data and that things can always change going forward. With the world economy going in all different kinds of directions currently, we don’t know what the future will bring.
Only consider focusing on mid cap and small cap stocks when you are okay with the additional volatility and are investing for the long term.
Investing in index funds makes the diversification process very simple.
M1 Finance makes the process even easier! They charge no trading or annual fees & you can set up automatic investments with them!
What is your opinion on Large Cap vs. Mid Cap vs. Small Cap stocks?
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