When choosing stocks and funds for your investment portfolio, it’s important to have a basic understanding of market capitalizations and investment styles.
Comparing Market Caps
Market capitalization refers to the total market value of all outstanding shares of a company’s stock. A simplified example: if a company has 1 million outstanding shares and each is worth $10, then the market capitalization of the company is $10 million (1,000,000 x $10).
Small-cap stocks are issued by smaller companies and generally have the highest growth potential and investment risk. Small capitalization generally refers to those companies at the bottom 10% of the market cap spectrum. They usually have market caps of less than $1.5 billion. They are likely to be more sensitive to economic ups and downs than larger-company stocks, and as a result can quickly rise and fall in value. Small-cap stocks tend to outperform large-cap stocks during periods of economic growth, but past performance does not guarantee future results.
Mid-cap stocks are issued by medium-sized companies that are often attractive targets for takeover by larger companies. They are often less volatile than small-cap stocks. Growth rates of mid-cap stocks tend to be more sustainable than small-cap stocks but not as consistent as large-cap stocks.
Large-cap stocks are issued by large, well-established companies, with market capitalizations over $10 billion, or basically the largest 2/3 of all publicly traded companies. They may not have as much growth potential as small- and mid-caps, but tend to be fairly stable and may even pay dividends. When the economy slows, investors tend to prefer large-cap stocks over small-cap stocks to help manage or limit market risk. Large-caps often have more resources than smaller companies to maintain stability during tough economic times. It's important to understand that stocks can move between categories. For example, if a small-cap company's stock goes up dramatically, it could easily move into the mid-cap category.
Comparing Investment Styles
Growth stock funds typically invest in well-established companies with above-average prospects for long-term growth. These companies usually have track records for fast-growing sales and profits measured by earnings growth rates, return on equity, book value and cash flow. The stocks may be expensive and possess high price-to-earnings ratios, but the growth investor believes the price will continue to rise along with company earnings. Earnings are usually reinvested into the company for research and development rather than paid out as dividends. Growth-style investing tends to be more aggressive than value-style investing, so stock prices have potential for large gains and losses. Start-up companies and many technology and healthcare companies may be growth stocks.
Value stock funds, on the other hand, typically invest in companies believed to be undervalued – companies that have been overlooked by the market, those experiencing temporary setbacks or showing potential for turnaround in an industry that’s currently unpopular. Value investments are purchased at low prices in relation to their earnings, dividends, cash flow or book value, with the expectation that the firm's value will go up in the future. Because value stocks are already “cheap,” they may be less vulnerable to market downturns than full-price stocks. However, it is important to note that a stock can continue decreasing in value to a bottom of $0, if investors and/or customers lose faith and the company winds up in bankruptcy. Value stocks often pay dividends, which can help cushion falling prices.
Because growth and value investments don’t always share the same ups and downs of the market, it can make sense to invest in a balance of the two and/or consider blended investments. To achieve a healthy balance of growth potential and investment risk, you may want to invest in one of each type of funds that hold these market segments.
If you choose a fund that invests in a particular area of the market (whether it be a small cap, growth, or value fund), you should be able to find the corresponding market index (benchmark) in the prospectus. You can also achieve broad diversification by investing directly in index funds that cover an entire area of the market (e.g., the Russell 2000 index invests in the 2,000 smallest companies in the broad market, while the MSCI EAFE index invests in a wide selection of internationally based companies). There are typically growth and value oriented versions of most major indexes.