GUEST POST: Why I Am Investing My 401(k) in Small Caps

By Nate Matherson, Co-founder of a personal finance blog called LendEDU. Nate is a 25 year old working to build a portfolio for a lifetime.

Making retirement investment decisions can be complicated, as you need to balance potential risk versus potential reward.  While putting money into the stock market is typically the best approach for investing and saving for the future, there are a lot of choices about where to allocate those investment dollars.

For me, I’ve made a choice that perhaps some might consider to be unconventional. I’m putting most of my retirement funds into small cap stocks. In particular, I’ve chosen to invest in Delaware Management Company’s Delaware Small Cap Value R Fund.

I’ve decided to concentrate my investments heavily in this fund largely because I feel that there are long-term benefits to investing in small caps versus other alternatives such as choosing a target date fund that puts money into a mix of different assets based on desired age of retirement.

If you’re curious as to why, here are some of my motivations for choosing a small cap fund – along with some details about what small cap stocks are, what the benefits are of investing in them, and what the potential downsides are.

What are Small Cap Stocks?

Small cap stocks are stock shares in companies that have a pretty small market capitalization. Market capitalization refers to the market value of all of a company’s outstanding shares. In other words, it’s the value of all of the shares of company stock being sold.

While the exact definition can vary, small caps are usually companies that have a market capitalization of between $300 million U.S. dollars and $2 billion U.S. dollars. While this may not seem that small, keep in mind that the market capitalization of Apple computer is $917.32 billion as of July 8, 2019. 

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Small caps are an alternative to midcaps and large caps, which are companies with higher market capitalization ratios. They are, however, not the stocks with the absolute smallest market capitalization. Nano caps are stocks with a market capitalization of under $50 million while micro caps are companies with a market capitalization of $50 million to $300 million.

Small caps also aren’t penny stocks – many companies considered small caps sell shares for more than $1 per share, and small caps can be sold on any stock exchange.

What are The Potential Long-Term Benefits of Investing in Small Caps?

Source: Marketwatch

The most consistent high-performance winner was small-cap value stocks. Except for the 1930s, this asset class produced decade-long gains that were always over 12.5%.”

Many people recommend choosing a target date fund, which invests in a mix of different size companies by buying some small caps, some mid caps, and some large caps. However, I prefer to concentrate on investing in small caps for my retirement because there’s huge growth potential with these smaller enterprises. And, as seen in the image above, small caps have outperformed the S&P 500 Index and Large-Cap Value asset classes for most of the last century.

By investing in innovative small cap companies, I can get in on the ground floor with companies that have the potential to change the future of commerce. Naturally, this means I have the chance to make much more money over the long-term. After all, it’s a lot harder for a company with a $10 billion market cap to double in value than for a company with a $300 million market cap to double in value. That larger company already has a huge share of its target market, while the small company has tremendous potential for growth.

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Small caps also tend to be overlooked by analysts and Wall Street investors, and mutual funds rarely buy them since mutual funds to invest huge sums of money in companies and small cap companies can’t support investments of that size. Because of this, there’s a greater chance that small cap stocks are underpriced and it’s easier for the average investor to spot promising companies to invest in at a bargain.

What are the Downsides?

There are also some big downsides to small cap investing. First and foremost, you’re taking on much more risk when investing in small caps because you’re hoping the company will be successful at scaling up – and it’s hard to predict when this will happen. Smaller companies also have smaller customer bases, so may not be able to survive rough patches or economic downturns.

When investing in small cap funds, which is what I’ve chosen to do, fees also tend to be higher — in part due to the fact that more time and skill is necessary for fund managers to find good small cap companies. Paying higher fees can eat away at the higher returns small cap stocks potentially provide.

Why I think the Upsides Outweigh the Downsides for Me

Despite these downsides, I feel investing in small caps is the way to go for me right now. I believe that over a long period of time small cap outperformance will more than cover the additional fees charged by investing in more specific funds. I’m young and have lots of time to grow my investment accounts. And, as a company owner myself, I believe in the power of smaller companies to revolutionize their industries and grow into big, valuable businesses. The risk, to me, is worth the potential reward.

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