Understanding market capitalisation

What you’ll learn:

• How combining exposure to different sized companies can help manage your risk and rewards.
• The definition of large, medium and small companies.
• Why it's important to get the balance right.

When it comes to investing, size matters. When you’re putting together an investment portfolio, it’s crucial to understand how the potential risk and return of shares in a company are impacted by its size. That means looking at a company’s market capitalisation.

The definition of large, medium and small companies – or large, mid and small caps – fluctuates as stock market values rise and fall.

The 100 largest companies in the UK by market capitalisation make up the constituents of the FTSE 100 index and represent roughly 80% of the market capitalisation of the London Stock Exchange. The medium segment of the market is listed in the FTSE 250 index, which represents around 15% of UK market capitalisation, and below that is the FTSE Small Cap index. An index of even smaller firms is contained within the FTSE Fledgling Index.

The FTSE All-Share is the aggregation of the FTSE 100, FTSE 250 and FTSE Small Cap indices, representing 98-99% of UK market capitalisation.

Why size matters

Larger companies are generally well-established in mature industries and among the dominant players in their sectors. They’re usually well-known names in their own right or the makers or suppliers of well-known brands. Generally speaking, they’re usually solid businesses that can pay out a portion of their earnings in dividends.

Importantly though, because of their already considerable size, they tend not to have significant growth rates. This means their shares are unlikely to appreciate rapidly. On the other hand, they have tended to suffer less than smaller companies’ stocks in bad times because investors often view large, well-established companies as relatively safe during market volatility. As a result they also have a reputation as ‘defensive shares’.

For instance, major oil company BP took a huge financial hit following the disastrous Deepwater Horizon oil spill in 2010, and more recently saw profits plunge in 2016 thanks to low oil prices, but it’s still far less likely to go bust than a small oil explorer. However, during periods of severe market volatility, blue chip share prices can fall considerably, as was the case with financial stocks during the crisis.

Large caps are often multi-national businesses too, meaning they’re exposed to the global economy and movements in foreign currencies. They’re also closely followed by analysts, so there’s plenty of research material for investors and fund managers to study. But the downside of this is that it’s difficult to find insights that aren’t widely available. Small companies aren’t usually as well researched.

Smaller stocks are riskier

Smaller companies are typically far more volatile than larger businesses as they have the potential to grow profits very quickly, which can be reflected in rapid share price rises. But they’re also more vulnerable to shocks and can lose money quickly, which in turn can send their shares plummeting. Medium-sized or mid-cap companies, which range from big household names to more obscure specialist firms, tend to display characteristics of both large and small caps.

Small cap companies are also often young businesses and in many cases are operating in new or niche markets, such as technology. They usually have the potential for rapid growth and their agility means a successful acquisition, a product launch or a move into new territory can make a material difference to their profits and their share price performance.

However, the potential for large returns comes with a higher risk. Small caps, by their nature, are more fragile as they may not have a solid track record and can be vulnerable to setbacks within the business or in a broader economic downturn.

In addition, their general lack of international exposure means their fortunes tend to be closely tied to those of the domestic economy. In the worst case, if a company runs into trouble, shareholders may not get back any of their investment.

Although many small companies pay dividends, some may be unable to do so because they make little or no profit, while others may reinvest the money in the business to help further growth.

Mid-cap firms tend to be more dynamic than their blue-chip counterparts but more dependable than small companies. As such, on the risk spectrum, they typically lie somewhere in the middle.

Getting the balance right

Given the typical characteristics of the different market segments, your tolerance for risk will determine whether you’re inclined to focus on the large or mid and small end of the scale.

Generally speaking, investors should aim to construct a diversified portfolio spread across various markets and asset classes. These offer different potential returns based on varying degrees of risk, helping to ensure that losses in one area will have a limited impact on your overall portfolio. Investing across different market segments based on company size can be part of the diversification process.

Find out more about diversifying your investments

Always remember that regardless of whether or not you diversify, the value of all investments can fall as well as rise and you may get back less than you invested. Past performance isn’t a reliable guide to future performance.