Investing is often likened to sailing. As investors, we must learn to navigate the turbulent seas of the market, taking advantage of favorable winds while steering clear of threatening storms. In the vast ocean of investing, smallcap stocks are the speedboats - swift, agile, and capable of generating exhilarating returns, yet susceptible to rough weather. Today, we delve into the choppy yet potentially rewarding waters of smallcap investing, examining both the risks and rewards.

Risks of Investing in Small-Cap Stocks

Historically, smallcap stocks have consistently provided higher returns than largecap stocks. This can be attributed to several factors.

Volatility

With great potential comes great risk, and this is particularly true for smallcap stocks. These stocks are known for their volatility, with prices capable of making wild swings in short periods. While this volatility can be profitable, it can also lead to significant losses.

Smallcap stocks have a higher level of market risk or beta. They are often less established with less stable financials, and they seldom pay dividends, thereby leading to increased market risks.

Lack of Resources

Compared to largecap companies, small-caps often have limited resources. They might lack the financial resilience to withstand tough economic times or the capacity to invest in growth opportunities. Additionally, they may not have a proven management team in place, making their future performance more uncertain.

Limited Information

Another challenge with smallcap stocks is the lack of readily available, reliable information. Because these stocks are not followed as closely as large-cap stocks, investors may find it more difficult to make informed decisions about these companies' prospects. This lack of coverage or 'information risk' can dissuade some investors.

Liquidity Risk

Small-cap stocks typically have higher liquidity risk. They usually have a narrower investor base, making them less liquid assets. Trading volume, a measure of liquidity, tends to be lower for small-cap stocks. As a result, substantial investments or withdrawals by institutional investors can drastically swing the stock price.

The aforementioned risks lead to the potential for higher returns, aligning with the risk-return tradeoff principle. Essentially, the greater the risk, the greater the potential return, and small-cap stocks certainly carry their fair share of risk. However, these incremental returns may compound to significant differences over a long period.

Rewards of Investing in Small-Cap Stocks

Despite these risks, the less followed nature of small-cap stocks can also present opportunities. With fewer analysts tracking them, these companies may have undervalued aspects that the market hasn't fully recognised yet, leading to potential profit opportunities for perceptive investors.

High Growth Potential

Arguably, the most enticing aspect of smallcap stocks is their high growth potential. These are typically young companies that are carving out a niche in their industry, and their small size allows for faster, exponential growth compared to their larger counterparts. If you identify the right smallcap stock, you could be in for a highly lucrative ride.

Undervalued Opportunities

Smallcap stocks are often under the radar of major institutional investors due to their small market capitalization. This lack of attention can lead to these stocks being undervalued, presenting a wonderful opportunity for savvy investors to purchase these hidden gems at bargain prices.

Diversification

Investing in small-cap stocks can add another layer of diversification to your portfolio. These stocks often perform independently of large-cap stocks and can provide positive returns even when the broader market is struggling.

As such, while investing in small-cap stocks does present unique challenges and risks, the potential for higher returns compared to large-cap stocks has been a compelling historical trend. As always, a well-diversified portfolio and careful consideration of individual financial circumstances and risk tolerance are key elements of successful long-term investing.

Positives of Smallcaps

Small-cap stocks, despite their higher market, liquidity, and information risks, have a positive side: they have historically yielded higher returns compared to large-cap stocks. A potential annual increment of 2-3% may seem small, but these additional gains can compound into considerable differences over extended periods.

Take for instance the internet bubble in the late 90s. While large tech companies like Dell, Microsoft thrived, small-cap stocks struggled to compete, resulting in their underperformance over five consecutive years. However, investors who can stomach market volatility and maintain patience may find opportunities in small-cap stocks, despite their traditionally higher volatility. Small cap stocks exhibit about 40-50% greater volatility than large-cap stocks do, majority of this coming during down markets.

Investing in small-cap stocks can be accomplished both actively and passively. For those leaning towards passive methods, index funds and Exchange Traded Funds (ETFs) provide an avenue to invest in baskets of small-cap stocks without needing to research and select individual stocks. A significant milestone in this domain was the creation of the Russell 2000 Index in 1984 by Frank Russell and Company. It presented a basket of the smallest 2,000 stocks out of a pool of 3,000, measured by market cap. The index allowed investors to participate in the small-cap market, and it is updated annually to account for changes in firm size and market presence.

The Russell 2000 Index today is the most widely followed small-cap index in the US, with over 90% of small-cap investment managers using it as their benchmark. The index was born out of a need for a performance measure for small-cap stocks, a niche that was unfilled at the time. Other indices, such as the S&P small-cap index of 600 names, exist, but none have gained as much traction as the Russell 2000. Thus, despite the risks, the potential for higher returns and accessibility of small-cap stocks can make them an attractive part of a diversified investment strategy.

Conclusion

Investing in small-cap stocks is akin to sailing in uncharted waters. The journey can be risky, filled with high waves and unexpected storms. But for those willing to do the research, remain patient, and embrace volatility, the potential rewards can be quite attractive. Remember, every investor has a unique risk tolerance and financial objectives. Therefore, it's essential to consider these factors before deciding how much of your portfolio should be allocated to small-cap stocks.

As with all investing strategies, it's often best to seek advice from financial professionals who can help steer your investment ship safely and successfully towards your financial goals. Investing in smallcaps can be a rewarding voyage, but it's one best embarked upon with a well-charted course and a seasoned navigator at your side.

Learn more about the trending Wright Smallcaps Portfolio. Be sure to check out the next article in this series: Smallcaps learnings from Great Investors: Warren Buffett, Peter Lynch & Michael Burry.