For new investors, understanding how to invest in small cap stocks can be a learning process. These companies don’t offer the same familiar recognition that large cap companies do. There’s also a fine line between a promising small cap and a junk penny stock. Thankfully, there are more than a few ways to invest in small cap stocks safely.

How you choose to invest in small caps can depend on your risk tolerance, as well as your core investing thesis. Are you enamored with an up-and-coming company and willing to buy the stock directly? Or, do you prefer the promise of small caps in general and feel good about the performance of a small cap index? There are more options for small cap investing than many people realize. Here’s a look at them, and the pros and cons of each. 

Investing Through Exchanges

The simplest and most direct way to invest in small caps is through a major exchange, like the NYSE or NASDAQ. Here, you’ll find small caps that meet SEC filing requirements, which makes them a safer bet than some off-exchange products. Search by sector or fundamentals to find small caps that meet your investment criteria. 

When investing in individual small cap stocks, there are some key fundamentals to consider. P/E ratio is a good indicator of how the market values the company. Cash flow is crucial to consider, since small caps often face significant cash struggles. Alongside this, debt-to-equity ratio can tell you a lot about the company manages its finances. Sales and income are also vital—you want a company that’s growing, not stagnating. 

Once you find a company that offers a healthy balance sheet and promising prospects, investing is as easy as placing a market order. Be warned that small caps tend to be volatile investments on their own, so you’ll need to stomach the risk that comes with a one-off investment.  

Over-The-Counter Trades

Looking for big-time boom-or-bust potential from a small cap? You’ll find it on over-the-counter markets. OTC markets play host to companies that don’t (or won’t) meet SEC filing requirements and exchange listing costs. It’s also important to consider the size of OTC companies:

• Small cap: Small caps blur the line between OTC and exchange listing. These are companies valued between $250 million and $2 billion.
• Micro cap: These are companies valued at less than $250 million. They tend to be struggling companies or those with heavy balance sheets.
• Penny stocks: Any stock valued below $5 is a penny stock. While there’s opportunity for these small and micro caps, they’re subject to significant risk. 

There’s much more diversity for OTC investors. For example, you’ll find international small caps in OTC markets. You’ll also find long-tenured small caps poised to take their next step by listing on an exchange. There’s value OTC, but even more risk to consider. 

Small Cap ETFs

Don’t want to bear the burden of investing in any one single small cap company? A basket of companies can mitigate risk and provide you with more exposure to a broader range of sectors. This is the purpose of a small cap ETF. These investment products naturally mitigate the risk of volatility through hedging, and are often much more stable products for small cap investors. There’s also a diverse range of small cap ETFs out there:

• iShares Russell 2000 ETF 
• Vanguard Russell 2000 ETF
• iShares Core S&P Small-Cap ETF
• SPDR S&P 600 Small Cap ETF
• Vanguard S&P Small-Cap 600 ETF
• Schwab U.S. Small-Cap ETF

The downfall of an ETF is that stability comes at the cost of upside. ETFs can perform well, but may not pace the growth of more promising single stocks. An ETF might see exponential growth from ABC small cap company, but see its share price dragged down by XYZ company. The beauty of ETFs is that they rebalance over time and based on performance. 

Through a Small Cap Index

The surest and safest way to bring small caps into your portfolio is through an index fund. Small cap indexes actually have a history of outperforming large caps and blue chip stocks. Investing in a small cap index is a bet on equilibrium—after all, it’s a representation of average performance. While there aren’t as many index options as there are ETFs, the major small cap indices will generate market-beating returns: 

• Russell 2000 Index
• Fidelity Small Cap Index
• Northern Small Cap Index
• Praxis Small Cap Index
• Vanguard Small Cap Index

The biggest drawback to investing in a small cap index is that you’re tethered to the average. Even an ETF can offer sector-specific exposure; an index offers total market exposure. An index will always net you the average. And while a small cap index average might outpace an index like the S&P 500 or Dow Jones Industrial Average, it often comes in lower than small cap ETFs or single securities. 

Invest With Caution and Optimism

Investing in the stock market comes with volatility. In fact, it doesn’t matter which type of stock you have interest in. For the latest expert stock analysis, sign up for the Profit Trends e-letter below. This newsletter gives you invaluable stock tips, trends and market movement unlike anywhere else. And it’s completely FREE.

As you get familiar with how to invest in small cap stocks, remember to always weigh risk vs. reward. A single stock could be a ticket to the moon or it could be a dead spot in your portfolio. Likewise, a small cap index might outshine blue-chip stocks, but won’t take off like individual companies you’ve had your eye on. Learning to balance this risk and reward is the key to successful investment in small cap stocks. Invest with caution, but don’t be afraid to invest with optimism.

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