There’s a good chance you’ve heard the term “market capitalization” — or market cap for short — but perhaps you aren’t sure exactly what it means. Well, this is one of those fancy-sounding investment terms that is actually very simple.
Market capitalization is a measure of a company’s size at a given point in time. It is calculated by multiplying the number of shares outstanding by the share price. So if a company has one million shares of stock outstanding, and the current share price is $50, its market cap is $50 million.
Simple, right? But how should market cap factor into the decisions you make about investing your money? The answer lies in the concept of diversification.
Going Beyond Asset Classes
A well-diversified portfolio consists of the right mix of investments — based mainly on your goals, time horizon and risk tolerance — across the three primary asset classes of stocks, bonds and cash equivalents. For example, an investor might decide that his portfolio should consist of 40 percent stocks, 40 percent bonds and 20 percent cash equivalents.
However, there is a wide range of different types of stocks and bonds. Therefore, a diversification strategy should go deeper than just the three primary asset classes to include the different kinds of stocks and bonds you should hold in your portfolio.
Stocks can be segmented into a number of different categories, one of which is company size. And this (you guessed it!) is determined by a company’s market capitalization. In general, companies will fall into one of the following market cap segments:
— Market cap is less than $50 million.
— Market cap is between $50 million and $500 million.
— Market cap is between $500 million and $2 billion
— Market cap is between $2 billion and $10 billion.
— Market cap is between $10 billion and $50 billion.
— Market cap exceeds $50 billion.
Many mutual funds and exchange-traded funds (ETFs) target companies with specific market caps, which makes it easy to diversify your portfolio by company size. In addition, some funds further target companies by industry and country, which enables you to narrow your investment choices even further. A mid-cap emerging market fund, for example, would target mid-sized companies in emerging nations.
Why Market Cap Matters
Diversifying your portfolio according to market cap is important because different sized companies tend to have different risk/return characteristics. Large-cap companies, for example, often have the lowest risk, but also the least potential for high returns since they usually do not offer as much growth potential as smaller companies. However, they often pay dividends that help boost overall returns.
On the other end of the spectrum, many small-cap companies have lots of room to grow so they can offer tremendous return potential. But there is usually a higher risk, since these are often young business without an established track record, often operating in risky industries such as high-tech. Mid-cap companies generally occupy the middle ground between these two segments in terms of risk vs. reward.
The most important thing to remember when it comes to market cap is that it is a tool that can help you diversify your investment portfolio. Choose mutual funds and ETFs targeting the market cap segments that will enable you to achieve the right level of diversification for your investment goals, time horizon and risk tolerance.