In addition to diversifying among asset classes, investors may also want to balance the securities in their portfolios according to company size, or market capitalization.
While a company's size can be measured in terms of its sales, investors also need to assess its size in terms of market value. Market capitalization, or "market cap," refers to the total value of all of a company's shares of stock. It is calculated by multiplying the price of a stock by its total number of outstanding shares. For example, a company with 100,000 shares selling at $10 a share would have a market cap of $1 million.
Market cap measures not only what a company is worth on the open market, but also the market's perception of its future prospects because it reflects what investors are willing to pay for its stock.
Small, medium, large
All companies are categorized according to their market capitalization as small cap, mid cap, or large cap.
Investors need to take these categories into account because companies with different market caps have distinct risk/return characteristics and tend to perform differently depending on market conditions. However, there are no strict rules defining these categories - and the ceilings for each has, historically, gone up.
Small cap companies usually have a market cap of between $150 million to $500 million, although many investors stretch that definition to include companies with a market cap of as high as $1 billion. Small cap companies are also relatively risky but have experienced rapid growth.
Mid cap companies can have market caps ranging anywhere from $500 million to $5 billion. These companies tend to have achieved a degree of stability while still experiencing growth on their way to large capitalization.
Finally, large cap companies have market caps of $5 billion or more. This category includes the big blue chip companies that are household names to most investors. Although investors in stocks in any market capitalization category incur risk, surprises have traditionally been less likely among these blue chip companies.
While the categories of market capitalization are fluid and changing, most investors would agree that market cap is the most important determinant of a company's size because it reflects market value, and therefore, expectations about a company's future. Companies with tremendous growth potential but relatively small sales numbers may have high market caps as investors bid up the stock price.
Understanding and assessing the market capitalization of companies is crucial to making smart investment choices. Because companies with different market caps tend to perform differently over different time periods, diversifying among companies with various market caps can reduce risk and volatility in a portfolio and maximize investment returns over the long haul.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.