Here are a few reasons why investors should consider incorporating a limited portion of their portfolios to small caps.

Let’s begin this journey with clarifying what are small capitalization companies. One way to categorize publicly listed companies is by their size, or market capitalization, which is really a fancy term for a simple calculation that you arrive to after multiplying the number of outstanding shares by the stock’s market price.

Categorizing Companies As Per Their Market Capitalization

Over the years, categorizing companies as micro caps, small caps, large caps, etc. has changed dramatically. What used to be a mid-size company a couple of decades ago, these days most likely could barely make it as a small cap. Although there are no clearly outlined rules how to classify companies according to their size, it has been generally accepted that small caps are companies with market capitalization from about $300.0 million to $2.0 billion.

Addressing Small Caps' Lackluster Reputation

Now, with basic definitions out of the way, let’s address the blaring issue of small caps’ reputation, or rather, the lack thereof. By all means, small caps are considered very risky investments, often implicated in all kinds of manipulations, and even more often lacking in quality fundamentals.

However, in hindsight, the same could be said about, for example, the likes of Enron and WorldCom. Although these two companies were once large caps and everyone’s market darlings, in the end they proved to fit the “bad” small cap mould on all three counts.

Small Caps' Huge Growth Potential

Perhaps this is why supporters of small caps often argue that size, although it matters, is neither a sure way to lose millions of dollars nor a guarantee of spectacular future returns. But first and foremost, making the case for small caps is their enormous growth potential. At one point, even large and mega-large caps have started out as small businesses, and as such, they had much easier time doubling and tripling in size than companies that have already grown to market sizes of over $100.0 billion or more.

Flying Low Under the Wall Street's Radar

Another advantage of small caps is that while still in the development stage, they are usually not yet on the Wall Street’s radar. You may find small cap analyses on the Internet by independent analysts or paid stock promoters, but hardly ever are known analysts going to extend their coverage to small caps.

There are two reasons why. Firstly, mutual and hedge fund are generally restricted by what types of securities are allowed into a fund, at what risk level, or in which sector. And secondly, small caps cannot handle hundreds of millions of dollars that portfolio managers can allocate to a single investment. Of course, the upside of small caps having little or no coverage from the Street is the likelihood of their stocks being undervalued.

Undervalued Is Not the Same as Discounted

Just make sure not to equate undervalued stocks with discounted stocks. When a stock is undervalued, it generally means that certain positive microeconomic developments have not yet been factored into its market price. In contrast, a discounted stock is often on "sale" because it has fallen short of market expectations, and usually with a good reason.

Small Caps Are Highly Speculative Plays

As with most things in life, there is a flip side to investing in small caps, too. When you invest in small companies that are still in development stages and where money is tight, you are exposing your own investment to a significantly higher risk level. At the end of the day, all companies are judged by their ability to generate cash, among other things. In majority of cases, large caps are excellent moneymaking machines.

Small caps, on the other hand, are still at the stage when they are trying out their business models, or buidling their long-term assets, or investing in research and development, all of which costs money. In other words, they are more likely to hemorrhage cash than milk it.

Finally, due to their size, small caps are less liquid, and therefore, more susceptible to market volatility. Huge price swings within days are nothing unusual for small caps. However, not every investor has the stamina to stomach them.

Regardless, there is much to be said about the kind of growth opportunities that only small caps can offer. Although with small caps comes a lot of baggage, (in the form of excess risk), the potential for significant returns should not be ignored.

Bear in mind, however, since small caps are highly speculative investments, our advice is to ensure that all mechanisms are in place to limit potential losses, such as building stop loss limits right into the first trade, and more importantly, investing only the money you can afford to lose.