Market Capitalization: Large Cap Vs. Small Cap

You may have never heard of "Market Capitalization," but there's a good chance that you've heard of "large cap" or "small cap" stocks before. As usual the financial world goes out of their way to make something fairly simple sound pretty complicated. In its simplest sense, market capitalization is simply a measure of the company's total worth.

We calculate that by multiplying the number of shares in circulation times the price per share. In other words, the market capitalization of a stock is how much money it would take to buy all the shares of the stock.

So what good is it to know the "market cap" of a stock? You and I aren't planning on buying out any of these companies anytime soon. But stocks of similar capitalization have a tendency to behave in the similar ways. So if you're seeking diversification, consider making sure your stocks are from different levels of capitalization. Of course what exactly are those levels is another question.

Large Cap

There's no technical definition for when a company becomes "large cap," but analysts tend to use a line of roughly $4 or $5 billion in market cap as the cutoff. Large cap companies tend to be large corporations like Wal-Mart, IBM, and GE.  These traditionally stable companies can offer more predictability, so market peaks and valleys for them tend to be smaller.  This combination offers you the ability to ride the market on a few large cap companies for quite a long time with less danger of a total crash, but less opportunity for a big payout.

Small Cap

Small cap companies, on the other hand, are typically smaller, less stable, and more youthful companies.  Buy-ins for small cap investments are relatively low with a higher possibility of a large return if the company takes off.  However, small and youthful companies have a higher risk of failing, and your investment could slide as well.  If you know the company, the product, the advertising, the market availability for their product, and/or the company leadership -- and you believe the company will take off -- small cap investments can be very lucrative.  The dangers, though, can include a total loss of your investment.

The Fickle Market

The stock market is subject to ebbs and flows based on news, stock indications, and public nervousness.  By mixing small cap and large cap stocks you can benefit from different factors in the markets. You can also weight your portfolio according to your beliefs as to whether market conditions favor large cap or small cap stocks. For example, during the dot com boom of the late 90's and early 2000's, small cap stocks were the rage and had a huge run-up. Of course this was followed by a swift decline as well.

Understanding the differences between large and small cap stocks and what capitalization means in general can help you be aware of the risks of your portfolio. If you go look at your 401(k) there's a good chance that many of the mutual funds you own invest in large cap or small cap stocks. Now you can take a look at your holdings and have a better understanding of what they mean -- and what you want to do next.

Photo Source