Reasons Why Investors Need to Consider Small Cap Stocks

Investing Basics |

When it comes to investing, there's always some degree of risk involved, which is why financial advisers recommend portfolio diversification. Treasury bonds and other futures, blue chip stocks and dividend-paying companies across different industries are all sound investment options for safeguarding your portfolio against huge losses.

For the more aggressive strategies of investing, small-cap stocks are a great option.

What is a Small Cap Stock?

This particular stock refers to smaller companies where the dollar value for the total outstanding shares is between $250 million and $2 billion, depending on the broker assessment.

Small caps have unclear growth potentials, lack the full transparency of larger corporations and are subject to price fluctuations of more than 5 percent on any given trading day. As a result, small caps are considered extremely risky. However, where there's high risk there's also the potential for a high reward.

The Benefits of Small-Cap Investing

The most obvious benefit to investing in small caps is the earning potential. Buying shares while the price is low and the company is small creates an enticing earning potential if that company grows significantly. This is especially true if the small cap is undervalued, which can occur when a company receives little or no attention from market analysts.

The other benefit lies in the fact that investors aren't competing with large mutual funds eager to buy as many outstanding shares as possible.

Mutual funds avoid small caps since the law prohibits them from buying the amount of shares they'd need for the investment to hold any value as part of a fund. This means small investors can get in when the earning potential is high and walk away after the value surges -- all before the mutual fund enters the picture.

The Risks of Small-Caps

The major risk associated with small caps is volatility. The low volume of shares being traded means price swings are more common when a large number of shares are traded. You can be down 7% today and up 10% tomorrow.

Another issue that investors have to deal with is that small caps tend to lack media attention, which translates into a perceived lack of transparency and flow of information. While companies report earnings and filings as required by the SEC, sometimes additional communication may be hard to come by. Companies that communicate regularly to their shareholders and potential investors help to alleviate some of those issues. Overall, it's up to the investor to conduct their own analysis and due diligence based on the available data to decide whether any stock, big or small, is right for their investment strategy.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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