Small Cap Investing

Small Cap Investing

This investment strategy suites those looking to take on a little more risk in their portfolio. Small cap investing means buying the stock of small companies with smaller market capitalization. It is usually between $300 million and $2 billion.

Truth is that small-cap stocks are appealing to investors due to their ability to go unnoticed.

What does it mean?

Small cap stocks have less attention on them because

1) investors stay away from their riskiness and 2) institutional investors (like mutual funds) have restrictions when it comes to investing in small cap companies.

Small cap investing should only be practiced by more experienced stock investors as they are more volatile and therefore tricky to trade.

Annual returns by market value

The large caps may have millions of buyers and sellers. But it’s much more unfrequented in the small-cap world because comparatively few shares trade among fewer investors.

One of the most popularly accepted passive growth strategies is investing in small-cap companies.

There are solid practical data supporting this strategy. But it is questionable whether the extra returns obtained by this strategy are actually excess returns.

The small stock has become much more volatile since 1981.

That was a decade with high inflation, so the small stock premium has something in connection with inflation.

The transactions expenses of investing in small stocks are notably higher than the expenses of the transaction of investing in larger stocks. And, further, the premiums are estimated earlier to these costs. This is usually true. The different transactions charges will not explain the degree of the premium over time. Moreover, it can be even less crucial for longer investment.

The difficulties of the small company premiums are shown in the image above.

Small caps can be volatile and, consequently, risky. But, these risks are controllable with the suitable order setups, diversification, decent timing, and averaging systems. There are various types of risk:

Market risk: Meaning, the stock market can to do anything to the prices of any particular stock.
Liquidity risk: You will not be in a position to sell stocks for the prices you desire or demand.
Cash-flow risk: This is linked to leverage, or purchasing with borrowed money.
Diversification risk: When investors hold too less or too many various positions.
Economic risk: An economic downturn can modify the profits of companies.
Knowledge and experience risk: Lack of those two lead to catastrophe.
Tax and inflation risk: Analyzed individually, they may appear almost positive. Putting them together can be destructive.

The value of exercise and diversification grow even more prominent if you want to be a small cap investor. As small-cap stocks are separated in a few divisions, you will want a bigger part of the portfolio to be diversified with small cap stocks.

Besides, diversification should reduce the influence of estimation risk and information risk.

When investing in small-cap stocks, the reliability of success will often be your responsibility as an investor. That’s because there are no analysts following the company so you will have less help.

Small Cap stocks

You may have to go beyond the financial statements and scour other sources such as local newspapers, the firm’s customers and competitors, in order to find relevant information about the company.

Small-cap stocks have a long time horizon.

We explained already what are the elements and variations of the triangle.

And you know what is resistance and support and how to recognize them in the charts.

So, when investing in small-cap stocks, if a new price goes above the resistance line, there is a good possibility a “breakout” is underway. That means the share price may dramatically rise. Similarly, if a new price goes below the support line, which is a “breakdown”, the stock may decline significantly.

This range between resistance and support also defines a stock’s volatility over the period. The smaller the range between the two, the lower the volatility. Since volatility is often used as a substitute for risk, You should measure risk by the breadth of the “channel.” Do you remember what the channel is? Check it!

Within the trading range, and with the resistance and support lines as references, you have to search for six important patterns:

Double tops or bottoms
Head and shoulders
Flags and pennants

Take a look at some real example.

TSLA stock chart

Look at the space between the highest and lowest price that a stock typically reaches within a period of time. This picture from StockCharts shows a trading range between the red and green horizontal lines.

The red line across the top of the chart is the resistance line and noted the highest prices per share that buyers had paid in the given period. The green line across the bottom is the support line and indicated the lowest prices settled during the same period.

If a new price goes above the resistance line, there is a good chance a “breakout” is moving and the share price may dramatically increase. Thus, if a new price goes below the support line, a “breakdown”, the stock may decline significantly.

This range between resistance and support determines a stock’s volatility over the period. The smaller the range between the two, the lower the volatility. Since volatility is often used as a surrogate for risk, you have to measure risk by the amplitude of the channel.

The tactics for making good timing decisions:

Set profit goals in advance.

Reduce holdings after a profitable move, or take profits on some of your position. Leave the rest to ride with what seems to be a continuing trend.

Use trailing stops to manage possible losses.

Study the fundamentals always. This is particularly valid for small caps, which can shift directions or alter the company model.

Mark the leveling of trends: No trend lasts forever. It is good to be informed of the leveling before other investors.

Follow moving averages and other signals. Be careful about the use of averages balances short-term price volatility.

Quiz yourself about Small Cap Investing in the following quiz:

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