Investing in Small Caps

Guide: Advanced Trading

The risks and rewards

Private investors have a distinct advantage over their bigger and richer brothers, the institutional investors, when it comes to investing in Small Cap stocks (the smaller quoted companies on the stock market).

The investing rules of the institutions often prohibit them from investing in minnows. There are two main reasons for this: The belief that small means risky and the worry that buying and selling stock in Small Cap companies can present problems.

It is fair to say that both reasons have some validity. Smaller companies usually do not have the strength in depth that is enjoyed by their bigger cousins and so are more vulnerable to commercial setbacks and economic downturns. Large companies can survive cash problems by living off their fat; newer businesses may not have the wherewithal.

Small capitalisation can also mean restricted availability of stock and institutions, and mutual funds usually want to buy and sell in big quantities. Not only is it sometimes difficult to bundle together enough shares to satisfy a big requirement but there is further hassle when a substantial holder wants to sell out. A major percentage sale could adversely affect the share price and therefore jeopardise the company.

However, despite the inherent risks, investing in Small Caps can have some big advantages for the private investor.

The absence of heavyweight competition leaves the profit field open to the savvy private investor or investment club. He or she should mitigate the risk factor by doing the right research, and that means making sure that the company has enough money available to survive the bad times.

Meanwhile the share liquidity problem - not enough stock around to attract the big traders - will not be a concern to those who do relatively small trades.

In short, the fact that larger institutions often turn their back on the Small Cap sector can be an advantage rather than a disadvantage to private investors. By doing careful research into overlooked stocks you can spot the diamonds in the rough.

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