Why Investing in Small-Cap Is Riskier

Small-cap investors enjoyed a great year in 2020.

When looking at small-cap vs large cap-performance, it’s plain to see.

In 2020, the Russel 2000, a small-cap index, produced a 20% return, surpassing the S&P 500’s 16.3% return.

But since March 2021, the small-cap market has moved laterally.

But why are small-cap funds falling?

Between market factors changing, inflation, and the inherent risk that comes with investing in small-cap stocks, small-cap companies had a rough year in 2021.

Despite vaccine breakthroughs allowing economies to rebuild their strength, the latent effects of shutting so much down have fallen on small, domestic companies the hardest.

This has left new and veteran investors asking: “should I invest in small-cap funds.”

If you’ve read our other articles and newsletters, you know we’re all about the small-cap market.

But we’re also about being transparent to risk.

Once you understand the risks of the small-cap market, you’ll begin to see the rewards of smart investing.

Stock Market Factors Have Shifted

The US economy continues to recover from the ongoing pandemic, a positive sign for investors.

But not every part of the market is doing so well.

Small companies, typically the most vulnerable to unfavorable conditions, are impacted the most.

If you haven’t been paying attention to the news, the US is facing both a labor shortage and worldwide supply chain issues.

These factors can not only hurt the whole economy, but they can be fatal to small companies.

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The Small-Cap Market During Inflation

Over the past 20 years, 10-month yields for S&P SmallCap 600 have been 1.1% and the Russell 2000 1% when interest rates were 2.1%.

In the same period and conditions, the S&P 500 and S&P MidCap 400 both returned 1.1%.

That’s because falling interest rates usually indicate incoming growth for the economy, which small-caps greatly benefit from.

In the months following declining inflation, the SmallCap 600 gained 1.4% when inflation declined to 0.5%.

The Russel 2000 returned 1.3% following a declining inflation rate to 0.4%.

Are Small-Cap Companies Riskier Investments Than Large Cap Companies?

Simply put, small-caps are much riskier than large-caps.

For those wondering what qualifies as a small-cap, they are companies that hold a market capitalization in the range of $300 million – $2 billion.

Large-cap companies sit at $10 billion and above, and are much more risk-averse.

Between the two is the mid-cap market. What is a mid-cap stock?

A mid-cap stock is a company with a market capitalization between $2-$10 billion.

As you can see, small-caps don’t have the same capital to keep themselves up and growing as mid- and large-caps.

Without financial resources to back them up, they’re inherently more vulnerable to failure.

The 4 Risks of Investing in Small-Cap Stocks

Before entering the small-cap market, assess these four risks. These are not meant to discourage you from pursuing any one small-cap company. However, knowing these risks can help you avoid getting involved with the wrong stock.

Less Liquidity
Compared to other asset classes, small-cap stocks have less liquidity.

The easiest way to understand liquidity is how fast an asset can be traded on the market at a price that reflects its actual value.

This means that they’re harder for investors to find or possibly unavailable at a price they want or they’re not at a favorable price to sell.

It’s harder to turn your investment into cash when you want a good return.

Lack of Capital
The reason why companies like Apple, Disney, and Amazon are able to stay afloat despite unfavorable conditions is that they have greater access to financial resources.

Small-cap companies don’t enjoy this luxury.

Most small-cap companies are start-ups that lack the capital to fund new ventures or improve exciting ones.

On top of that, when conditions turn unfavorable, small-caps lack the resources to keep themselves operational.

Without funding, it’s hard to grow much less survive in today’s market.

Lack of Awareness
Hand in hand with a lack of resources is a lack of awareness.

Most investors neglect the small-cap market for three reasons.

It’s risky, there’s a lack of reporting and analysis, and company history within the small-cap market.

If no one knows about your company, it’s harder to grow and compete with the bigger dogs.

This gap in awareness can play a major role in consumer preferences, meaning it’s harder for small companies to establish a consistent brand base.

Unproven potential
Without an established company history, it’s difficult for investors to feel confident in a company.

Small-cap companies have a tough time attracting new investors because smart investors want to do their research first.

With no history to research, most investors pass without a second thought.

But their loss can be your gain.

The Rewards of Investing in Small-cap Stocks

Although the first two reasons for why small-caps are riskier are unlikely to work in your favor, the last two can.

Here’s how.

The lack of forecasting and analyzing small-cap stocks from market reporters ensures that fewer investors will dabble in them.

In other words, hidden gems in the small-cap market will stay hidden for longer.

When fewer investors are competing for shares in a company, you have a better chance to get undervalued stocks.

Being that these companies are small, their potential to grow is much higher than a well-established company.

It’s much easier to go from a one million dollar company to a five million company than a 300 million company into a billion-dollar company.

Smart investors will not ignore the small-cap stock opportunities.

With the right information from a credible source in the small-cap market, your small-cap returns could beat the market.

Learn More About Minimizing Risky Investments

There is no investment without risk. Dear Retail exists to help you be aware of risks while helping you profit off the small-cap market. We provide our community of like-minded investors with supplemental knowledge, exclusive investment opportunities, and so much more. To have access to reliable stock market information and the latest news, become a Dear Retail Investor today.

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