Small cap investing is an area of the market that has been in favor with investors for years. It is hard to go wrong when you invest in small cap companies such as  companies with a market capitalization under $1 billion. Plus, there is further appeal for small-cap growth stocks because they can offer greater potential growth which will lead to higher returns than large-cap or mid-sized companies. However, most people do not realize how much risk is involved with investing in primarily smaller and faster growing companies.

There are many positives with investing in smaller sized enterprises; however, one must also be prepared for the possibility of greater volatility and more risk than with larger company stocks . According to Russell Investment Group, out of 175 global markets analyzed between 1982 and 2011, smaller company stocks have had about twice the volatility of large caps .

Small companies are not without risk. It may seem that investing in a small cap stock with a high growth potential is a smart move, but it might be even smarter to diversify your investment by buying a few different small caps rather than putting all of your eggs in one basket. Smaller sized companies also have greater room for errors and there is also more speculation involved with investing in these types on enterprises. In comparison to larger corporations, small-cap stocks tend to rise on hot rumors and fall harder during times of crisis, such as the 1987 market crash or 2001 11th September terrorist attacks on New York’s World Trade Center . Due to this volatility, sticking to a well-thought out plan is essential for those considering investing in smaller companies.

Smaller company stocks are still important and they do have a place in your portfolio, but remember that it is not without risk. However, there is ample room for growth as the small cap arena continues to become more popular among individual investors.

Overview of Small Cap Investing Risks

Although there are many risk factors in investing, the following list breaks down the majority of risks into five categories by their source :

1. Systematic Risk Factors

2. Diminishing Returns

3. Taxes & Inflation

4. Behavior Risk Factors

5. Volatility-Based Risks (Market or Industry Crashes)

Systematic Risk Factors            

Systematic Risk Factors are generally market related and cannot be avoided through diversification . They include political instability, war, inflation, recessions, stock market corrections , etc. Investing in international securities reduces risk from some of these systematic factors, but it does not eliminate the risk altogether.

Diminishing Returns

Diminishing Returns are, as one might expect, returns that decrease over time. The most common occurrence with diminishing returns is dollar-cost averaging , which is an investment strategy where you buy more units of a security when it’s price is low and fewer units when its price is high . However, this can lead to less overall growth due to buying more expensive securities. Another factor of diminishing returns occurs when the investor only looks at their balance sheet instead of looking both backwards and forwards within their life expectancy.  

Taxes & Inflation

Taxes & Inflation are often overlooked by investors because they are difficult to predict . It can be very risky investing in something if you do not know what or if there will be capital gains taxes or inflation. These two factors can change the value of your investment over time and not in your favor, which is why it is important to understand what you are getting into before investing.

Behavior Risk Factors

Behavior Risk Factors are personal actions that can affect your portfolio . According to author Richard Ferri , some behaviors that could cause problems include: poor market timing, excessively risky behavior (i.e. chasing high returns), buying on emotion, engaging in unethical activities at work, refusing to learn about investing, etc.

Volatility-Based Risks (Market or Industry Crashes)

Volatility-Based Risks are due to events such as a stock market crash or industry downturn . The most recent example would be the 2001 stock market crash after the 11th September terrorist attacks . Then, upon realizing the extent of its damage, investors panicked and sold their holdings which triggered a series of events that led to more people selling . By doing this, stock prices dropped even further due to supply outweighing demand.

Volatility-Based Risks are essentially industry specific. According to author Bill Bernstein , some industries are more volatile than others, including: technology companies , financial services firms , health care stocks , etc.

Summary

As long as you know what you’re getting into before investing in smaller companies, the risk will be worth it if your investment is successful. Additionally, by following diversification guidelines and being aware of systemic risks affecting investments worldwide , you can protect yourself from any major setbacks . Diversifying your portfolio is essential to protecting your assets and continues to be more important as technology progresses.