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Are Small Cap Stocks a Good Way To Diversify Your Portfolio?

By Marc Guberti
small cap stocks to buy

Diversifying your portfolio mitigates risk. Investors often wonder which small-cap stocks to buy for portfolio diversification and if these assets make sense for them in the first place. Growth for large-cap companies is often sluggish, unlike small-cap companies, which grow at faster rates. 

Let’s dive into stocks and which small cap stocks to buy.

What is a small cap stock?

A small-cap stock is any publicly traded company with a market cap below $2 billion. Small-cap stocks receive less attention than their large-cap counterparts, which allows investors to outperform the rest of the market.

A common misconception is that small-cap stocks are penny stocks. The defining feature of penny stocks is that they trade for no more than $5 per share. So, while some small-cap stocks fit those criteria, other small-cap stocks exceed $5 per share.

However, when deciding which small-cap stocks to buy, you shouldn’t focus on the share price. That number tells you nothing about whether a stock is overvalued or undervalued.

How should I choose stocks for my portfolio?

Before you pick stocks for your portfolio, assess your risk tolerance and investing style. Younger investors with high-risk tolerances and more time to work with can more comfortably invest in high-growth stocks because they can wait out any dips in the market. 

These investors gravitate towards stocks with higher valuations all while believing the companies will justify those valuations in the future. Investors with lower risk tolerances who are also nearing retirement often lean towards safer blue-chip dividend stocks. 

They don’t want to risk an overvalued stock tumbling, so they opt for stocks with more attractive valuations. Beginner investors should slowly build up their portfolios to gain more experience and only risk a small amount of money at any given time.  

In the stock market, it’s possible to build your portfolio with as little as $1 per month. Picking the right stocks takes considerable time, but MoneyLion can help! 

A MoneyLion investment account gives you access to personalized portfolios catered to your risk tolerance and other factors. Let the pros handle your portfolio so you can focus on increasing your income and contributing more to your portfolio every month. 

Get started with a MoneyLion investment account today!

Are small cap stocks riskier?

Small-cap stocks find themselves further along the risk-reward scale than their large-cap peers. Large-cap stocks capitalize on stable revenue streams, which leads to modest growth over time. The predictability of these companies’ revenue streams results in lower valuations compared to their small-cap counterparts.

Small-cap stocks tend to achieve higher revenue growth, which pushes the stock price. However, the increased revenue growth leads to dangerously high valuations in some cases. 

Small-cap stocks derive their lofty valuations from their potential revenue years from now. If these companies fail to deliver on their expectations, their stock prices can tumble drastically. 

The reverse scenario is that a small-cap stock continues to increase its revenue and profits, which provides some investors with life-changing returns. While small-cap stocks present a higher risk, remember that all large-cap stocks were once small-cap stocks. The potential reward in the typical small-cap stock justifies the increased risk. 

When should I buy small cap stocks?

Deciding which small-cap stocks to buy is a matter of timing. Small-cap stock prices tend to swing more wildly than their large-cap peers. These wild price swings make it extra important to keep capital gains taxes in mind if you decide to sell your shares. 

When assessing which small-cap stocks to buy, review valuations and price history. If a stock is richly valued and near its all-time high, it makes sense to monitor the stock and buy it at its weakest point. 

If a small-cap stock has a lower valuation and that value is far away from the stock’s all-time high, it could be at a great buy point. Even so, investing in stocks provides you with no guarantees. You can only statistically increase your odds of making a return on your investment based on timing.

Are small cap stocks safe to invest in?

Small-cap stocks present the potential of outsized gains. While small-cap stocks carry higher levels of risk and potential rewards, these investments are safe because you can pull out of them at any time.

A MoneyLion investment account provides members with actively managed portfolios that are catered to their personal investing preferences. These accounts are backed by the expert advice of Wilshire Associates to optimize the portfolios for the highest returns.

For investors feeling jittery about picking which small-cap stocks to buy or looking for guidance regarding their investment decisions, MoneyLion is here to help.

What should I look for when investing in small cap stocks?

When deciding which small-cap stocks to buy, consider a company’s growth prospects and valuation. Soaring revenues at a decent valuation provide more potential upside for both the company and the share price. 

However, soaring revenues paired with a dangerously high valuation is indicative of upward momentum for the company, though there will be challenges in terms of keeping the share price high. Many investors utilize the price-to-sales ratio for growth companies not reporting profits. 

It’s essential to look at and consider any and all net losses to ensure the company is narrowing losses over time rather than unsustainably increasing losses as their revenue increases. Investors often utilize the price-to-earnings ratio for profitable companies to determine if they are valued fairly.

What is an example of a small cap stock?

Alpha and Omega Semiconductors (AOSL) is an example of a small-cap stock. Although AOSL is not a penny stock, seeing as it trades for more than $5 per share, its market cap does not exceed $2 billion.

The company has produced outsized gains year-to-date, but the stock has underperformed during other years. The company is an emerging player in the semiconductor space, which leaves plenty of potential upsides. However, it could also travel a quick path towards a downward motion if cracks appear in the growth narrative.

Large-cap vs small-cap stocks

Large-cap stocks tend to provide heightened safety in exchange for lowered returns. The high revenue growth of small-cap stocks opens the door for significantly higher returns in the long run. 

However, with much of a small-cap stock’s valuation based on future growth, these stocks can quickly fall if cracks emerge within the growth narrative. Large-cap stocks and small-cap stocks both find themselves appropriately placed on the risk-reward scale. 

Large-cap stocks represent lower risk for a lower potential reward. Small-cap stocks, on the other hand, represent a higher risk for a higher potential reward.

Boost your portfolio with small cap stocks 

Small-cap stocks allow you to generate outsized returns. While these stocks carry greater risks, the potential upside is hard to ignore. If you want guidance during your investing journey, MoneyLion has you covered. 
A MoneyLion investment account gives you access to fully managed portfolios that are customized to your preferences.

MoneyLion takes the complexity out of investing and allows you to get involved with various assets, small-cap stocks included. Get started with a MoneyLion investment account today!

FAQs

How do I start investing in a small stock?

You can invest in a small stock through a brokerage account like MoneyLion’s investment account.

Should I buy small-cap stock?

Small-cap stocks present higher potential rewards in exchange for higher risks. They make a great addition to most portfolios, but your risk tolerance will determine the right mix for you.

What are the components of a strong company?

Components of a strong company include high revenue growth, profits or narrowing losses, solid growth prospects, and a reasonable valuation.

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