Today, we'll start with three basic terms that define the investment strategy of many mutual funds: large cap, mid cap and small cap.
"Cap" is short for capitalization and basically describes the size of the company in terms of its stock market value. Market cap is determined by multiplying the number of shares of stock a company has issued by the stock price. That means a company's market cap can fluctuate, but those daily moves don't usually change its place in these three categories.
A Capital Idea
Apple (AAPL), Exxon Mobil (XOM) and General Electric (GE) are three of the biggest companies in the world. Apple, the world's largest company, has a market cap of approximately $570 billion.
Such giant companies make up the large cap sector. Large caps generally have a market value of more than $10 billion -- maybe $15 billion, by some definitions. That means they tend to be well-established companies with strong financial profiles, and many pay regular dividends.
The mid-cap sector is an often-unloved group in the investment world.
Small caps are generally valued at less than $4 billion. Many aggressive investors favor this group because these stocks are considered to have greater growth potential, but their stock prices are generally more volatile, so both the reward and the risk can be greater. In addition, they do not have consistent earnings and rarely do they pay dividends.
"Over the long term, small caps have tended to outperform large caps," said Matthew Coffina, editor of the Morningstar StockInvestor newsletter, even though some of the premium has become less prominent over the past decade or so. He also notes that small caps "appear relatively expensive right now."
Using This Information
How do you use market capitalization in making investment decisions? Most individual investors like you and me make our stock market bets by using mutual funds. There are thousands (that's for another day), but many stock funds have a mission to invest primarily in one group or another. Some use that in the name (Vanguard Small Cap Index (VSMAX) for example), but for the most part you have to read a bit of the fund's prospectus to understand its mission.
Very often, when people refer to "the market," they're talking about the Dow Jones industrial average (^DJI) or the Standard & Poor's 500 index (^GPSC) -- both made up of large cap stocks. And most investment advisers think that area should be in everyone's portfolio. Many recommend buying an index fund of large cap stocks and then diversifying with funds from the other groups.
"The larger caps have been around longer. They're financially stronger. They are lower risk," according to Marc Salzinger, publisher of The No-Load Fund Investor newsletter. He says that because people tend to think about the market in terms of large cap benchmarks like the S&P 500, investing in other types of funds raises your risk "of not earning what you expect" based on the year-to-year variations in performance between the stock groups.
While small cap stocks tend to outperform over the long-term, the year-to-year fluctuations for those stocks and mutual funds fluctuate more. The key to long-term investing success, according to Salzinger, is to "invest steadily, not panic and pick something decent."
In the next post of this series, we'll take a look at another way to divvy up your mutual fund investments by style -- growth, value, balanced and core funds.