What Makes Small-Cap Stocks Mighty (and Risky)

Investors salivate over the biggest companies in the market — the likes of Apple, Google and Amazon — but where’s the love for the market’s perpetual underdogs: small-cap stocks?

When these investments do get some time in the limelight, it’s often for unflattering reasons — violent price swings or fraudulent activity, for example.

If you don’t currently have holdings in these stocks or related funds, it might be time to add some to your portfolio. Small caps can diversify portfolios and bring higher growth potential — albeit with higher risks. Here’s what you need to know.

What is a small-cap stock, exactly?

Small refers to, well, small; cap is shorthand for market capitalization, or the total number of a company’s shares multiplied by its current stock price. In other words, small-cap stocks come from companies with total market values that are still relatively modest.

The definition of small is subjective, however. The Russell 2000 Index, the first benchmark of small-cap stocks, is the best-known gauge. The market caps of its member companies currently range from about $144 million to $3.4 billion. The other major indexes tracking these stocks — the Standard & Poor’s SmallCap 600 and the MSCI USA Small Cap Index — include U.S. companies with even broader ranges of market caps.

Why they’re unique

Many small-cap businesses eventually grow up into mid- or large-cap companies. Until then, they have some important differences from companies in the Dow Jones Industrial Average or Standard & Poor’s 500 Index, which track much larger stocks.

Tom Goodwin, senior research director at FTSE Russell, which oversees the Russell 2000 Index, breaks down what makes small-cap companies unique:

  • They’re generally focused on domestic business lines and therefore dependent on U.S. economic growth
  • Their revenue is derived from only a few lines of business
  • They’re more subject to U.S. taxes and regulations than their larger counterparts

Investors often use small caps to bet on whether U.S. economic growth will accelerate or decelerate. That was especially evident following the most recent election. The Russell 2000 rose 14% from the election through the end of 2016, more than double the comparable performance of large-cap gauges.

“When the election occurred, small caps really took off and that was largely because part of Trump’s economic agenda was cutting corporate taxes,” Goodwin says.

Why they’re risky

As small-cap businesses expand, their stocks offer a higher growth potential compared to larger companies. But that comes with a greater risk of volatility — including more (and bigger) fluctuations in stock prices and earnings reports. This trade-off is known as risk premium.

» MORE: Diversification: An easy way to reduce your investing risk

“Because these companies tend to operate a single line of business, if something goes right or wrong, that can dramatically affect price valuations in the stock market,” Goodwin says.

Small-cap stocks can also be more fertile territory for fraudulent activity. (Read more about how to detect stock market scams).

Why they’re mighty

The sheer number of small-cap stocks means there’s a plethora of options for investing in them. What’s more, the proliferation of exchange-traded funds has made it easier to buy a basket of stocks with a specific investing strategy — growth or value, for example. Small-caps can be an underappreciated — or even overlooked — way to add diversification to your portfolio.

Among 40 wealth management firms, the proportion of U.S. equity allocations to small-cap stocks was above 25% as of March, up from 20% in 2016, according to a survey by Barron’s Penta magazine.

Small caps historically have a relatively high correlation — meaning they tend to move in lockstep — with large-cap stocks. But which group is performing better than the other over a given time frame fluctuates regularly, based on factors such as macroeconomic growth and politics.

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Case in point: After their postelection surge, small caps are trailing large caps year-to-date. With shifts like these, a portfolio that has allocations to both groups will experience less volatility.

Why they’re not that different

It’s important to know what makes small-cap stocks unique, but you shouldn’t necessarily obsess over the differences. They have a lot in common with the others in your portfolio: They trade on exchanges, their prices are published intraday, Wall Street analysts write research reports about them, and by virtue of being public, these companies must disclose a wealth of information to investors.

Ready to go small? See NerdWallet’s tool to find the best stock broker for your needs.

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The article What Makes Small-Cap Stocks Mighty (and Risky) originally appeared on NerdWallet.