Sometimes, investment terminology is tossed around without really being explained…large-cap, small-cap, mid-cap - what exactly do they mean? The investment analysts at 401k Forum have decided to help you get down to basics with a series of articles about the different asset classes.
First of all, let's define asset classes. They're the categories that your different investments fall into - basic ones include cash, bonds, large-cap stocks, small-cap stocks, and international stocks, though there are a number of other more specific permutations. Studies have shown that the key to successful investing is to spread your wealth among different asset classes.
So let's get started. Up today: Large-Cap Stocks!
So what the heck do you mean by "large-cap?"
Large "cap" refers to a company's stock market capitalization, or the total number of shares multiplied by the stock's price. This is a gauge of what the market (or investors) believes the entire company to be worth. Microsoft, the largest of large-caps, is worth $430 billion, according to its market cap. Market caps change daily, as long as there is a change in stock price.
Large-cap stocks are a broad subset of the stock market. Generally considered integral to an investor's diversified portfolio, they tend to have fairly similar characteristics and so are grouped together. As a whole, large-cap stocks are an important part of the economy and therefore essential to asset allocation.
Larger companies tend to have a more established business presence and less uncertainty in sales or profits than smaller (small-cap) companies. Although there are exceptions, larger companies often have slower growth rates, but are less risky investments than many smaller companies. Large-caps are considered long-term investments, and 50+ years of historical market returns yield slightly lower than short-term returns, but with less volatility.
The path to "large-cap-dom" can vary from company to company. As long as the stock price goes up, so does market cap. Historically speaking, stock prices increase as a firm's earnings increase-just how much depends on how much a company can increase its future earnings, or rather, the market's perception of future earnings. Amazon.com made its way into large-cap territory rather quickly, because investors have been willing to buy the stock based on optimism that its rapidly rising price will one day reflect actual earnings. A rapid move to high stock prices due to investor enthusiasm is an exception, however, and most companies take many years to climb the ranks.
So just how large is "large-cap?"
It's safe to say that any company with a capitalization over $10 billion is classified as large-cap. (We'll be discussing small- and mid-cap stocks next time.)
Different indices (or market barometers) are used to represent large-cap stocks - the most well-known and widely used is the venerable S&P 500. Other large-cap indices include the Russell 1000 and the Wilshire Large Cap 750 Index. These indices are rebalanced periodically (usually on a semi-annual or annual basis) to reflect the changes in the market values of companies as their stocks increase or decrease in price.
These indices are often used as benchmarks for mutual funds and pension funds that invest in large-cap stocks. These money managers often invest in many of the same companies in the index, but many buy stocks outside of the index, or in different proportions, in an attempt to beat the index. Index funds generally invest in all of the companies in the underlying index in an attempt to exactly match its returns.
What kinds of companies tend to be large-cap?
The lion's share of large-cap stocks are in the technology, financial services and healthcare sectors, which makes sense given that these sectors play an ever-increasing role in the economy. Large-cap technology stocks such as Intel, Microsoft, IBM, Cisco Systems and Hewlett Packard are among the biggest players, as technology continues to be vital in the home and business. The companies that have helped create the technological revolution of electronic communications are among the biggest companies in the world.
Financial services is also a large sector of the economy, and has done very well in the low-interest-rate and bull-market economic environment. Many large-cap stocks, such as JP Morgan, American Express and Citigroup, are common household names among the large-cap financials. The baby boom generation presents a huge market for financial planning, investing and asset management that these companies are taking advantage of.
Also capitalizing on the baby boomers are the large healthcare and pharmaceutical concerns. Merck, Warner Lambert, Bristol Meyers, Eli Lilly and Pfizer are among the dominant large-caps in this area.
|(Source: U.S. Department of Commerce, August 31, 1999)
These sectors have propelled large-cap indices to superb performance in the last five years. The S&P 500, for instance, has returned 25.11% over the last 5 years versus an annual average of slightly over 10% since market indices began to be widely tracked in the late 1920s. Recent large-cap performance has overshadowed the performance of small-cap stocks, which returned 15.4% over the last five years. However, from 1926 through 1995, small-cap stocks outperformed large-cap stocks by 2% per year on average (12.5% for small-caps vs. 10.5% for large-caps), according to a study by Ibbotson Associates.
What does this mean for me, the investor?
Other than making for impressive cocktail party conversation, you may be wondering how this affects the average investor. Investing in different segments of the market (or asset classes) is the cornerstone of an asset allocation plan, and according to financial experts, is the single most important aspect of long-term portfolio performance. Large-cap stocks are an important piece of the asset allocation puzzle for most investors.
Reviewing your mutual funds and other investments with a critical eye, rather than thinking that all investments tend to behave in the same manner, can also be of use. Although many large-caps will perform differently, often they will more closely resemble each other than they will smaller stocks or other asset classes.
Now that the large-cap waters aren't so murky, you may find that investing is both more interesting and more complicated than you previously thought. For further insight into the world of investing and 401(k) plans, please visit the 401Kafe's interactive investing "college", Wall Street 101.