09 Sep Should I invest in small-caps or micro-caps?

Q. What’s the difference between small-caps and micro-caps? Should I have both in my portfolio?

A. In layman’s terms, micro-cap companies are smaller than small cap companies.

By definition, small-cap stocks are companies that have capitalization — the outstanding number of shares times the stock price — of between $300 million and $2 billion, while micro-cap stocks are companies that have capitalization of $50 million to $300 million, said Jay Kota, an investment analyst with U.S. Financial Services in Fairfield.

“Micro-cap companies tend to be less liquid — harder to trade — less followed by Wall Street analysts and institutional investors, and have less float available as company insiders tend to retain majority of the shares,” Kota said. “These characteristics tend to be both a blessing and a curse.”

The characteristics of micro-cap stocks are a big part of the reason why these stocks have provided a higher return than other asset classes. For periods ending March 31, 2015, over 25-year, 50-year and 75-year periods, the lowest segments the Center for Research in Security Prices (CRSP) database — equivalent to the micro-cap universe — have shown additional returns of 2 to 4 percent over large-caps, Kota said.

“For strategic portfolios that are measured over years, an allocation to micro cap stocks in addition to small-cap stocks can have potential added return benefits with volatility reduction,” he said.

However, micro-caps also tend to be highly correlated with small-caps, he said and the higher return of the micro-cap comes with higher volatility, Kota said.

“This means that at any given time, due to the same characteristics driving the higher average annual returns, a micro-cap holding can see severe losses due to liquidity and marketability risks,” he said.

For example, for calendar year 2008, the Russell Microcap Index was down 39.78 percent and for the month of August 2015, that same index was down 5.4 percent.

Before considering what should be in your portfolio, you need to consider your aversion to risk.

“If this type of drawdown is not palpable, the investor is better off allocating only to small caps, as small caps will generate returns that are near those returns of micro-caps,” he said.

Small-cap companies tend to move a lot and can become mid-cap companies in a short period of time, said Reed Fraasa, a certified financial planner with Highland Financial in Riverdale.

He said micro-cap companies are thinly traded and information on them is sometimes hard to find.

“For those reasons, it is advisable to purchase a small-cap or micro-cap mutual fund,” Fraasa said. “Many small-cap funds will also hold some micro-cap stocks as well.”

He said you should always hold some small-cap stocks in your portfolio. He recommends taking a look at Vanguard Funds for a small-cap fund that tracks the Russell 2000 for a good start.

“You will likely only want to have between 5 and 15 percent of your portfolio in a small-cap fund,” he said.

Email your questions to .

This story was first posted in September 2015.