Small-Cap Stocks vs. Large-Cap Stocks: What's the Difference?

Small-Cap Stocks vs. Large-Cap Stocks: An Overview

Historically, market capitalization, defined as the value of all outstanding shares of a corporation, has an inverse or opposite relationship to both risk and return. On average, large-cap corporations—those with market capitalizations of $10 billion and greater—tend to grow more slowly than mid-cap companies. Mid-cap companies are those with a capitalization between $2 billion and $10 billion, while small-cap corporations have between $250 million and $2 billion.

These definitions of large cap and small cap differ slightly between the brokerage houses, and the dividing lines have shifted over time. The differing definitions are relatively superficial and only matter for the companies that are on the borderlines.

Small-Cap Stocks

Small-cap stocks have fewer publicly traded shares than mid- or large-cap companies. As mentioned earlier, these businesses have between $250 million and $2 billion of the total dollar value of all outstanding shares—those held by investors, institutional investors, and company insiders.

Smaller businesses will float smaller offerings of shares. So, these stocks may be thinly traded and it may take longer for their transactions to finalize. However, the small-cap marketplace is one place where the individual investor has an advantage over institutional investors.

Since they buy large blocks of stocks, institutional investors do not involve themselves as frequently in small-cap offerings. If they did, they would find themselves owning controlling portions of these smaller businesses.

Lack of liquidity remains a struggle for small-cap stocks, especially for investors who take pride in building their portfolios on diversification. This difference has two effects:

1. Small-cap investors may struggle to offload shares. When there is less liquidity in a marketplace, an investor may find it takes longer to buy or sell a particular holding with little daily trading volume.
2. The managers of small-cap funds close their funds to new investors at lower assets under management (AUM) thresholds.

Large-Cap Stocks

Large-cap stocks—also known as big caps—are shares that trade for corporations with a market capitalization of $10 billion or more. Large-cap stocks tend to be less volatile during rough markets as investors fly to quality and stability and become more risk-averse.

These companies comprise over 90% of the American equities marketplace and include names such as mobile communications giant Apple, multinational conglomerate Berkshire Hathaway, and oil and gas colossus Exxon Mobil. Many indices and benchmarks follow large-cap companies such as the Dow Jones Industrial Average (DJIA) and the Standard and Poor's 500 (S&P 500).

Since large-cap stocks represent the majority of the U.S. equity market, they are often looked at as core portfolio investments. Characteristics often associated with large-cap stocks include the following:

1. Transparent: Large-cap companies are typically transparent, making it easy for investors to find and analyze public information about them.
2. Dividend payers: Large-cap, stable, established companies are often the companies investors choose for dividend income distributions. Their mature market establishment has allowed them to establish and commit to high dividend payout ratios.
3. Stable and impactful: Large-cap stocks are typically blue-chip companies at peak business cycle phases, generating established and stable revenue and earnings. They tend to move with the market economy because of their size. They are also market leaders. They produce innovative solutions often with global market operations, and market news about these companies is typically impactful to the broad market overall.

Key Differences

There is a decided advantage for large caps in terms of liquidity and research coverage. Large-cap offerings have a strong following, and there is an abundance of company financials, independent research, and market data available for investors to review. Additionally, large caps tend to operate with more market efficiency—trading at prices that reflect the underlying company—also, they trade at higher volumes than their smaller cousins.

Small-cap stocks tend to be more volatile and riskier investments. Small-cap firms generally have less access to capital and, overall, not as many financial resources. This makes it difficult for smaller companies to obtain the necessary financing to bridge gaps in cash flow, fund new market growth pursuits, or undertake large capital expenditures. This problem can become more severe for small-cap companies during lows in the economic cycle.

Despite the additional risk of small-cap stocks, there are good arguments for investing in them. One advantage is that it is easier for small companies to generate proportionately large growth rates.

Sales of $500,000 can be doubled a lot more easily than sales of $5 million. Also, since a small, intimate managerial staff often runs smaller companies, they can more quickly adapt to changing market conditions in somewhat the same way it is easier for a small boat to change course than it is for a large ocean liner.

Likewise, large-cap stocks are not always ideal. As mature companies, they may offer fewer growth opportunities and may not be as nimble to changing economic trends. Indeed, several large companies have experienced turmoil and have lost favor.

Just because it's a large cap, doesn't mean it's always a great investment. You still have to do your research, which means looking at other, smaller companies that can provide you with a great basis for your overall investment portfolio.

The Bottom Line

Small-cap stocks and large-cap stocks both come with their own pros and cons. While small-cap stocks can generate higher returns, they also have a higher risk profile. Conversely, large-cap stocks witness smaller growth but are more stable. Investors should consider investing in both for a balanced portfolio.