How Investors Use Market Cap to Diversify Their Portfolio

Updated: Dec 9, 2021

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If you’ve spent any time looking at stocks, you’ve probably run into the term “market cap.”


But what the heck does “market cap” even mean? And why do investors use it to analyze a company?


Investors often use market capitalization to evaluate how large or small a company is…


Knowing the size of a company can be a great indicator for growth or for potential risk.


In this article, we’ll take a deep dive into market capitalization and why it’s important. We’ll go over how to evaluate the size of a company and how your calculations can help you diversify your investment portfolio.


First, why is it important to learn about Market Cap?

Smart investing is all about looking at the long term. You’ll have a more efficient investing experience if you understand that there is a relationship between a company’s size and its potential for growth.


Market Cap gives you an idea of how large a company is. And knowing how large a company is, gives you an idea of how valuable it is.


Knowing the size of a company’s market cap also allows you to evaluate both its risk and its potential for growth.


So, what the heck even is Market Cap?


By definition, the market cap is the total market value of a company’s outstanding shares of stock.


In other words, market cap refers to the total dollar amount of each possible share that a company issues to investors.


The market cap is a pretty straightforward concept.


You can usually find a company’s market cap by simply Googling the company’s stock information.


So you don’t normally have to do any calculations on your own.


But let’s go over an example of so you understand how market capitalization is calculated!


Let’s say that company ABC has 5 million shares. And when you look at your investment app, you see that each share is sold at $100.


To find your Market Cap, you would multiply your number of shares by the share price.


So in this case, it would look like this...


5,000,000 x $100 = 500,000,000


The Market Cap of ABC company would be 500,000,000…


All you have to do is multiply the number of shares by the share price and voila - you have your market cap!


It’s pretty simple when you put it that way, right?


But… what the heck does that number even mean?


That’s a great question! Let’s dive deeper together!


How you can use market cap in your investment strategy


Company size and risk


When we’re talking about market cap, company’s can be broken down into three sizes: small, medium, and large.


Kinda like McDonald’s french fries!


Yum!


But what are the characteristics of each size? Is it better to have large-cap or small-cap companies?


And the answer is - (just like Mcdonald’s french fries) it depends on your preference!


Let’s dive deeper and talk about what each size means...




Small-cap: Refers to companies with a market cap between $300million and $2billion. Small-cap companies are considered to have a higher risk for an investor because they are often younger and serve a smaller market. On the other hand, small-cap companies can also mean that they are in the early stages of their development and therefore have more potential for growth.

  • Medium-cap: Companies with a market cap between $2 billion and $10 billion. Medium-cap companies are often expected to have rapid growth because they have experience in the market and are in the process of expanding. Medium-cap companies have a higher risk than large-cap companies because they have not been established yet. They’re attractive because of their potential for growth, but this could also be a deceiving factor for investors if the company reflects all-around strong fundamentals.

  • Large-cap: Companies with a market cap over $10 billion. Large-cap companies are well-established companies with a strong reputation in their industry. Large-cap companies are a great opportunity for you if you’re a conservative investor and you want less risk. They usually have higher dividends and provide steady and certain growth. The potential downside to large-cap companies is that their growth would be slow and steady. They also usually have higher share prices. Which may make them a harder investment if you want to focus most of your portfolio on them. And if you’re looking for a company with rapid growth, you won’t find it in large-cap companies.

  • Micro-cap: Micro-cap is another size of a company that isn’t talked about as much. But they aren’t uncommon. Micro-cap companies refer to any company with less than a $500 million market cap. Like small-cap companies, micro-cap companies are more volatile and yield less certainty than their larger-cap counterparts.


When thinking about the size of a company, remember that there are pros and cons to all sized companies. And knowing the different sizes and levels of risk also allows you to strategize the risk diversity of your portfolio.


Diversify


Now that you understand the different risk factors that come with each market cap size, you can decide to diversify your portfolio.


You may see pros and cons to all small, medium, and large companies. But that doesn’t mean you can only invest in one out of the three.


Some financial experts report a higher return in investing the majority of their portfolio in small-cap companies, with a small percentage in large-cap companies.


Other experts report higher earnings from large-cap companies over a longer period of time.


At the end of the day, the diversity of your portfolio depends on your risk tolerance. If you’re willing to deal with high risk for larger rewards, then small-cap companies will be your best bet. And if you want more stability, then large-cap companies will be your best friend.


But remember that the market cap is just a piece of the puzzle. And any risk should be evaluated with more fundamental analysis.



Things to keep in mind about Market Cap


As we learned, the market cap is determined by the number of shares and the share price of a company.


This means two things can happen that could change the market cap.


  1. The share price can fluctuate.

  2. The number of shares can fluctuate.


We’ve all seen share prices fluctuate. So, we don’t have to go into detail about share price the rise and fall of share prices.


But let’s go over scenarios where the number of shares can fluctuate. Often times you’ll see shares increase in a positive light.

In other words, if you ever see a company increase its shares, that usually means the company is growing in a positive way. The company may be expanding, buying out a competitor, or launching a new product…


But if a company reduces its amount of shares, this is called a capital reduction. A company can have many reasons to reduce its amount of shares including revenue or profit loss.


What now?


At the end of the day, the market cap allows you to understand what to expect from a company.


But remember, just like any metric, the market cap is just a piece of the puzzle.


As an investor, you’ll learn to figure out your own process based on your values, goals, and your risk tolerance.


If you want to learn about other metrics to evaluate the fundamentals of a company, check out our article on Fundamental Analysis.


Even if you’re a high-risk investor, investing is a long-term game. And the best investment is in your own knowledge and skills.


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