The US and international stock markets can be broken down into groups of stocks based on the size of the issuing company. Understanding those groups and how to incorporate them into a portfolio can help investors better reach their long-term financial goals.
Typically, the stock market does a good job assessing the true value of a company through the pricing of its shares. In such cases, a company’s “market capitalization” and theoretical value should be roughly equal.
It is not uncommon, however, for a company to be acquired for a price that is either higher or lower than its market capitalization. This happens when factors not reflected in the company’s share price are considered in arriving at the purchase price.
Stocks issued by larger companies are referred to as “large cap stocks.” Stocks of mid-sized companies are “mid cap stocks.” Stocks of smaller companies are “small cap stocks.”
Stocks are generally categorized as large, mid, or small cap as follows. These definitions vary widely and are constantly in flux as the stock market moves up and down.
Large Cap: Over $15 billion in market capitalization
Mid Cap: Between $5 and $15 billion in market capitalization
Small Cap: Between $500 million and $5 billion in market capitalization
Categorization gets especially tricky near the breakpoints. For example, a $4.9 billion dollar stock does not immediately become a Mid Cap stock if it appreciates to $5.1 billion. Some will still consider it a Small Cap stock while others will have considered it a Mid Cap stock all along.
Here are some examples from each category as of December 2023:
Large Cap: Microsoft; Apple; Nvidia; Coca-Cola; AT&T
Mid Cap: Etsy; The Gap; Mattel; Domino’s Pizza; Victoria’s Secret
Small Cap: Levi Stauss ; La-Z-Boy; fuboTV; iRobot; GoPro
There are other categories of stocks based on market capitalization. For example:
Mega Cap: Over $200 billion in market capitalization
Micro Cap: Between $50 million and $500 million in market capitalization
Nano Cap: Under $50 million in market capitalization
These categories are used less frequently in building diversified portfolios. Micro and nano cap stocks represent a tiny part of the stock market, are less liquid, and more volatile than stocks of companies with larger market capitalizations. Some are already included in the small cap category. There are very few mega cap companies and they are already included in the large cap category.
Large cap stocks represent a significant part of the total US stock market, followed by mid-caps and then small cap stocks. Their approximate respective percentages of the US stock market are set forth below.
US Stock Market as represented by CRSP US Total Market index, November 30, 2023. Data Source: Morningstar.
Small, mid, and large cap stocks tend to have different performance characteristics. For example, small cap stocks historically have generated higher returns than large cap stocks over the long-term, but those returns come along with more risk in the form of volatility.
Large Cap and Small Cap are represented by the Ibbotson SBBI US Large Stock index and Ibbotson SBBI US Small Stock index respectively. Volatility as measured by standard deviation. Data Source: Morningstar.
Although over the long-term small cap stocks have produced greater returns than large cap stocks, they don’t do so on a year-to-year basis. Instead, as shown below, large and small cap stocks have outperformed each other in hard to predict cycles.
Between 1970 and 2022, small cap stocks outperformed large stocks 51% of the time.1
Ibbotson SBBI US Large Stock index vs Ibbotson SBBI US Small Stock index. Data Source: Morningstar
Because large, mid, and small cap stocks have differing performance characteristics, you may wish to diversify among these three “investment styles” in building a portfolio. There are many factors to consider in deciding whether and how to diversify among these styles of investing. Make sure the allocation you choose is appropriate for your financial goals and the risk and return targets of your portfolio.
Here are a few key concepts to remember when deciding how to allocate a portfolio among stocks from the different market capitalization categories:
If you decide to build a portfolio that focuses on one of the three main market cap categories, or use an asset manager who does so, it is important to select an appropriate benchmark to measure the performance of that portfolio or manager.
There are many indexes you could use as a benchmark for a large, mid, or small cap portfolio. For example, here are examples of benchmarks for each portfolio investment style:
Large Cap: S&P 500; Russell 1000; Dow Jones Industrial Average
Mid Cap: S&P Mid-Cap 400; Russell Midcap; Wilshire US Mid-Cap Index
Small Cap: S&P Small-Cap 600; Russell 2000; MSCI USA Small Cap Index
You could also select a mutual fund or exchange traded fund (ETF) that tracks one of these indices as your benchmark. One benefit of selecting a fund as your benchmark is that it includes management fees and trading costs in its performance calculations.
Keep in mind that each index is constructed differently. That is, each index creator includes different stocks and weights them differently in their index. So, it is important to make sure the benchmark you select is appropriate for the type of portfolio you are measuring against.
If you are building a portfolio that includes large, mid, and small cap stocks, you may wish to use a broad market index that includes all three investment styles, such as the Russell 3000. You may also select a fund that tracks a broad market index as your benchmark.
Alternatively, if you allocate your portfolio in a manner that is significantly different from the allocations of broad market, you may wish to create a custom index. For example, let’s say you build a portfolio that is allocated 40% to large-caps, 25% to mid-caps, and 35% to small-caps. Then you might create a custom benchmark that includes style-specific indexes allocated in the same manner.
The information contained herein does not constitute investment advice or a solicitation. This article is for dissemination of general information only. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results.