The stock market in November was fantastic. The Dow went up over 3100 points or 11.7%. Despite the pandemic and the chaos in the world, the market is actually up for the year (1055 points or 3.7%), which illustrates clearly the importance of staying calm and ignoring the talking heads on TV that constantly foretell doom. The topic of this newsletter will be Market Capitalization.
Market Capitalization (Also known as Market Cap) is simply what a company is worth on the stock market. It is the price per share multiplied by the number of shares outstanding. Market Cap is used as a way of categorizing companies because historically stock returns for large cap (over $10 billion), mid cap (between $2 billion and $10 billion), and small cap (below $2 billion) have all been different. As a rough rule of thumb, the larger the company, the lower the annualized returns have been historically. While there are time periods that are exceptions, over time a small cap index will most likely have a higher return than a large cap index.
The reason for these return characteristics is risk. In finance there is a relationship between risk and return. Riskier assets tend to have higher returns. As risky assets have a higher risk of default or bankruptcy than a non-risky asset, investors demand a higher return in order to assume that risk. For a risky stock that stock will only be purchased by investors if the price of that stock is bid down until it is cheap relative to its value. Most large cap companies have likely been around for many years, and have stable cash flows, profits, and expenses. Therefore, the chance of some catastrophic corporate event happening is low. Investors don’t need that much of a risk premium to assume the risk of investing because there isn’t much risk. Small cap companies of the other hand might not have a long lasting or reliable track record on cash flow, operating history, etc. The chance of a catastrophic corporate event is pretty high. Investors therefore need a high risk premium for them to assume that risk because they want to be compensated for taking on that high risk.
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Daniel and Eli
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