In the past 25 years, some of the most outstanding equities to invest in have been small-cap stocks. For example,  Amazon (NASDAQ:AMZN) was a $7 stock in 1998, and Tesla (NASDAQ:TSLA) had a market capitalization of just over $1 billion in 2010.

Of course, not every small-cap firm grows to be a large corporation. Small business investing can be gratifying, but it also has risks that investors must be aware of. Here’s an in-depth look at small-cap equities, including our recommendations for several of the best.

What are small-cap stocks?

Small-cap refers to a company’s share price times the number of shares outstanding. For example, when a firm’s market cap is between $300 million and $2 billion, it’s considered small.

Stocks are classified using market capitalization and typically divide as follows:

  • Micro-cap companies – Less than $300 million
  • Small-cap companies – $300 million to $2 billion
  • Mid-cap companies – $2 billion to $10 billion
  • Large-cap companies – $10 billion to $200 billion
  • Mega-cap companies – More than $200 billion

Small-cap firms are frequently young businesses. They have the potential for significant development but are also typically less stable than their bigger, more established counterparts. They are often losing money.

A comparison of the Russell 2000 (^RUT), a small-cap index, and the large-cap S&P 500 (^GSPC) since 2000 shows that small caps have had better performance than large companies. In general, small-cap stocks experience more stock value fluctuations than larger companies; however, over time, small caps are more likely to outperform their larger counterparts.

As of late, small-cap stocks have taken a severe nosedive due to the overall market’s anxiety over the Federal Reserve Board’s increasing rates. In addition, these smaller companies are primarily in their growth phase, so they lack solid footing compared to larger corporations. Plus, many of these businesses are unprofitable or just scraping by – making them even more susceptible during “risk-off” economies. In other words: small-caps perform poorly during bear markets but excel during bull markets.

Small-cap stocks now

Small-cap equities outperformed large caps from the market bottom in March 2020 through 2021. Still, jitters over anticipated Federal Reserve interest rate hikes have caused valuations to contract and small-cap equities to plummet in January 2022.

Small-cap stocks are more volatile, and as a result, they’re more prone to market downturns like the one in January 2022. Moreover, if interest rates continue to rise and concerns about the Fed’s monetary policy persist, small caps will likely perform poorly this year. Still, over the long run, small caps have a better chance of yielding high-growth winners.

Despite the retreat, the Russell 2000 Index still has a considerably higher price-to-earnings ratio than the S&P 500, reflecting that small-cap firms generally have lower earnings but more growth potential than their large-cap counterparts.

Should you invest in small-cap stocks?

Small-cap stocks might be right for you if you’re okay with owning a stock for a few years and don’t mind the price changing frequently. They can potentially increase your portfolio’s growth rate compared to other types of stocks, but only if you’re willing to stick to a buy-and-hold strategy.

As we saw during the pandemic, investing in small-cap stocks can be riskier than investing in large, established businesses. Make sure you do your homework before investing in any small company stock and consider diversifying your investment by putting some money into a small-cap fund.

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