What size is your market cap? Prudent investors know that company size is an important factor when building a portfolio. Large established companies tend to be more stable and predictable, while small companies with unproven potential can be risky investments. Is your market cap a good fit for you?
When it comes to the companies in your portfolio, size matters! Weight your portfolio too heavily with companies of one size and your retirement funds could be exposed to unnecessary risk or produce lackluster results. Confused about market cap? Here’s what you need to know.
Market capitalization, or market cap, represents the total value of a company. Some investors make the mistake of assuming a high stock price means a high company value. Not true. The stock price actually tells you very little about its value. The company’s market cap, however, represents the total value of that company’s equity shares.
Here’s an example:
In this example, Company A is the tech giant Oracle. Company B is Chipotle Mexican Grill restaurant chain. Chipotle’s share price is currently more than six times Oracle’s share price. But Oracle has a market cap that is more than 20 times that of Chipotle. We would all agree that market cap is the appropriate indicator of a company’s value, not its individual share price.
Market cap measures what a company is worth on the open market. It also measures the market’s perception of a company’s future prospects, since it reflects the value investors place on its stock. Investors can use market cap as one way to diversify their portfolios.
There are three generally accepted ranges or categories to describe market cap:
That’s a trick question! Your equity portfolio should contain more than one market cap. Why? Companies in each of these three categories will react differently in various market environments.
If you are over-exposed in risky areas, your portfolio could take a huge hit when you least expect it. If you construct your portfolio too conservatively, your investment return can suffer when risk-averse assets are performing poorly. However, pairing risky stocks with more stable investments can potentially boost your portfolio’s long-term return.
To build a portfolio with a proper mix of small-, mid- and large-cap stocks, you’ll need to evaluate your individual financial goals and risk tolerance. A diversified equity portfolio that contains a variety of market caps helps reduce your investment risk in any one area and supports the pursuit of your long-term financial goals.