Exploring the Negative Aspects of Small Cap Stocks

Small cap stocks are stocks of companies that have a market capitalization of somewhere between $300 million and $2 billion. This type of stock can provide several advantages to investors. However, at the same time, there are several negative aspects of investing in small cap stocks. Here are a few of the negatives of investing in small cap stocks.

Volatile

One of the potential negative aspects of investing in small cap stocks is that they tend to be very volatile. When compared to larger stocks, these stocks are going to vary greatly in price from one day to the next. Since these companies are very small, even the slightest news release or market sentiment can drastically change the outlook of the stock. If you are an investor, you need to be prepared for a roller coaster ride in your investment.

Long-Term Investment

Because of the volatility of this type of stock, investors should be prepared for a long-term investment. In most cases, investors look at this type of investment as a growth stock. This means that an investor should allocate at least five years to keeping money in this type of stock. Otherwise, you could try to time the market and get the timing all wrong.

Thinly Traded

Another potential disadvantage of investing in this type of stock is that it is thinly traded. This means that there is not nearly the volume that is present in the market with a large cap stock. When you are dealing with low trading volumes, it can have drastic effects on your trading. In some cases, there can be liquidity issues, and you will be dealing with large spreads between the bid and ask prices of a stock. This can increase the cost of trading and lower your overall profitability with any trade. In some cases, this can also drastically affect the volatility of the price of the stock. For example, if something negative happens to the company, there may not be enough buyers in the market to accommodate all of the sellers and the price could fall very quickly.

Lack of Dividends

Another disadvantage of investing in small cap stocks is that they rarely pay dividends. Companies that are still relatively small and trying to grow do not want to use any of their profit to go into dividends for the shareholders. Instead, they generally keep the extra profit and reinvest it into the company. By reinvesting money into the company, these smaller companies can help promote growth and get up to larger market capitalizations.

Some investors do not care about the lack of dividends with a stock and would prefer capital appreciation anyway. However, if you are the type of investor who likes to receive dividends, this type of stock may not be for you. Many investors like the thought of receiving regular income from their investments and want to reinvest the dividends into stock. If this is the case, you would most likely be better off investing in large cap stock. 

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