By Michael D. Bird, CFP®, MBA
Clients frequently ask, “What does it mean to be a large cap, mid-cap, or small cap company?”
There are many confusing things about personal finance but the investment question “Where do I put my money?” is a common one. If you ask that of a financial salesperson you might get the answer “we’re putting it into several different areas, including “large cap, mid cap and small cap” companies. What they’re trying to tell you is that your retirement savings will be invested in “large companies, middle-sized companies, and small companies”. The “cap” part of the description refers to its overall market value, or “capitalization”, which is nothing more than adding up all of the outstanding stock in the company and multiplying that by its stock price; “capitalization” is its value in the stock market. Why use the term “cap”? It’s financial short-hand. Unfortunately, unless you’ve read about it, it might not make sense. Why does it matter?
Understanding the lingo will help you understand the strategy. Large companies are typically well-established companies that have some history. Their businesses are operating as they have for some time and are producing profits, probably pretty regularly. Those profits may be great enough to generate enough cash that the company shares it with shareholders. In other words, they pay out dividends because they don’t have another use for it. And what’s important about this is that these large companies have stock prices that vary but, generally, are not going to go bankrupt overnight. They are perceived to be more stable.
Middle-sized companies aren’t quite as big but may be well-established, or they could be fairly new. They may pay dividends, or they may not. Generally, they are of interest to the investor that wants some growth but they also like the size of the company. Kind of the “goldilocks” of investment capitalization—not too big, not too small.
Small companies are exactly what you might think. They are generally not as well-established; they might be fairly new, and they are definitely a different kind of investment vehicle. Small companies typically don’t pay dividends, because they are putting as much as possible into growing the business. These are the companies that everyone would love to identify early (think Microsoft, Amazon, Walmart) and invest heavily. Unfortunately, their success rate on the order of a Microsoft or Amazon is pretty small. Still, the small percentage of companies that have huge success can offset the multitudes of companies that don’t. So, with small companies, it’s even more important to be widely diversified.
Another question that’s often asked is, “What’s the difference between stocks and bonds?” The easy answer is that stocks represent ownership in a company and bonds represent money lent to a company. For bonds, the investor has loaned money to the company for general financing needs, like new production plants or new equipment, etc. The bond represents the legal agreement between the investor and the company that in return for loaning the money, the company agrees to pay the investor a certain interest rate on that money. Usually the payments are made every 6 months. This makes it a good investment for someone looking for income. We are currently in a very low interest rate environment and bonds don’t have very high interest rates. When interest rates do go up, the value of the bond will go down. This is because these two characteristics of a bond, the interest rate and the value, move in opposite directions. For the investor that is willing to hold on to the bond, this doesn’t matter, because the company should continue to make the interest rate payments until the bond “matures.” In other words, the time expires when the company said it would pay back the original loan.
Putting all of these different investments to work for you is the art and science of financial advising.
And finally, clients sometimes ask, “Why didn’t we talk to you sooner?” That is a question that I wish I could answer to everyone’s satisfaction. But unfortunately, that’s just the reality. We have to start with where you are now and move forward. If you have your own questions, please feel free to contact me. This is a good time for questions!
Michael Bird, a Financial Advisor with Secure Money Masters in Bristol, TN, is also an adjunct Professor of Finance and has taught at several universities and colleges, including ETSU, Belhaven College and the University of Memphis. He currently teaches a course on Social Security and how to integrate Social Security benefits with Retirement Income.
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