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I want to understand the rationale to make the decisions to invest in small vs mid cap stocks. If there are any pointers for a non-finance expert, I will really appreciate it.

Thanks, Geo

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Small cap companies are just smaller, so the risk for them to fail is higher but the potential for higher returns is also higher.

  • hmm. So why financial savvy people call them small cap instead of aggressive or risky? Maybe that is a separate question. – Geo Feb 4 '11 at 19:52
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    @Geo: The "cap" is short for "market capitalization"; it's considered small if the company is worth less than $1 billion. It's also possible for a larger company to be a risky investment. – Bruce Alderman Feb 4 '11 at 22:32
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    And just to clarify a little further, market capitalization is the number of shares multiplied by a price. So it's kind of an indication what investors think the company is worth. – Vitalik Feb 4 '11 at 22:37
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Small companies are generally able to adapt quickly to take advantage of changing conditions to enter new markets when the economy is growing. This gives them a lot of growth potential under those circumstances. However, in times of crisis, there may not be a lot of new markets to enter, and financing to expand any operations may be impossible to get. Under these conditions, small-caps will suffer relative to large-caps.

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I think to answer this question it is best for you to learn more about why people diversify through asset allocation. Look at related questions involving Asset Allocation here.

I've asked a couple questions about asset allocation - I think you'll find the top rated answer on this post useful.

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In general, small cap stocks are exposed to more downside during recessions and when credit is tight, because it is more difficult for small companies to raise capital, and minor variations in cash flow have a bigger impact.

Coming out of recessions or when credit is cheap, small companies generally perform better than larger companies.

In the depths of recession, small companies with good cash flow are often great value investments, as analysts and institutional investors "punish" the entire class of smallcap companies.

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