Understanding risk – why company size matters

Investing in the stock market is risky business. It’s easy to get side-tracked by all of the investment opportunities out there, without fully getting to grips with the risks involved first.

But in a world where managing risk well is one of the biggest keys to investment success, we think investors need to know why not all risk is equal.

We take a look at why the size of a company matters and how to spread risk across an investment portfolio.

This article gives you information to help you manage your risk, but it isn’t personal advice. If you’re not sure of the best course of action for your circumstances, seek financial advice.

Big vs small – what’s the difference?

Companies listed on the stock market come in all shapes and sizes, across different industries and countries around the world.

So when it comes to putting together your investment portfolio, it’s important to understand the potential risk and reward of the companies you invest in.

One way to measure the risk of a company is to look at their size, otherwise known as market capitalisation. It can be calculated by multiplying the total number of shares in issue by the latest share price. This can be a handy riskometer for investors looking to spread their risk across companies of different sizes.

Large companies (sometimes called large-cap stocks) boast the biggest market value. They’re often the well-known names and market leaders in their field, who generate profits from lots of countries and have stood the test of time.

Given their size and stature, it makes them less vulnerable to takeovers from smaller rivals. They usually aren’t as dependent on the backdrop of the domestic economy to be successful either. This makes them less risky than smaller companies but means they’re unlikely to grow at a rapid rate.

Smaller companies on the other hand are amongst those with the lowest market value. Lots of these businesses are younger and are typically more domestically focused, meaning they carry out most of their business on home turf.

As a result, small-company shares are more sensitive to the fortunes of their own economy. This can make the shares more volatile than larger companies if the economy takes a turn for the worse.

That said, smaller companies generally operate in new or niche markets, so they have the potential to grow at breakneck speed. And let’s face it, the products and services we use to watch our favourite series or to video call our friends and family didn’t turn into household names overnight. But finding the next Netflix or Apple can be like finding a needle in a haystack and adds risk.

We don’t think investors need to sit on one side of the fence or the other. It’s almost impossible to know which size companies, sectors or geographies are going to perform the best from one year to the next. Spreading your money smartly across investments to build and maintain a portfolio that matches your attitude to risk is usually the best option.

Diversification – it takes more than a handful of stocks

Don’t gamble with your money

We don’t often draw parallels between the investing and gambling worlds but investors don’t take punts. We’re looking to grow our money over the long term. We want to become “the house”. The house doesn’t gamble. It simply manages its risk to maximise its returns.

As you can see from the chart below, the size of the company really did alter the amount of volatility. As a company’s size starts to go one way, the risk starts to go the other.

1 in 10 chance of making the annual loss shown for each sector/index

Past performance isn’t a guide to future returns. Source: Lipper IM, on a weekly basis from 31/12/2015 to 31/12/2020.

The chart shows that if you invested in the sector or index at a random point during 2016-2019, a year later you would’ve had a 1 in 10 chance of having suffered the loss shown (or worse).

Take a look at UK All Companies funds for example. The typical losses are significantly lower compared to individual shares as they often have a bias to large and medium sized companies, but also because your money’s spread across lots of investments. There was a one in ten chance of this sector falling by 14% or more in value over a random 12-month period within those five years.

However, switch your attention to the FTSE Alternative Investment Market (AIM) ex 100 index, which caters for the smallest listed UK companies – there was a 1 in 10 chance of the index falling by a whopping 64% or more in value over a random 12-month period from the same five years.

Is it really worth the risk? We don’t think so.

These figures aren’t designed to spook investors. But it’s important to understand the risks of certain types of companies before you go ahead and invest.

Although the stock market tends to perform better over the long term, losing large chunks of your investment’s value in a short period of time could make it difficult to recover from.

As an investor, you’ll need think about how much you’d be comfortable losing and build your portfolio from there.

Investing in individual shares, especially smaller companies appeal to many kinds of investors. They’re exciting, and usually have a great story behind them. But the numbers tell a different story.

That’s not to say you should avoid them completely as you could discover some hidden gems. But to get the right balance between risk and reward, we think these types of companies should make up a very small percentage of an overall portfolio.

When we think back to our core-satellite strategy, shares in smaller companies firmly sit in the satellite part of a portfolio for that added pop of adventure.

Tips to spread your risk

• Hold a mixed bag – putting all your eggs in one basket is a big risk. A diversified portfolio that holds a range of different sized companies will help reduce your risk. If one area performs particularly poorly, others areas could perform better and help pick up the slack. You can see how and where your money is invested by using the portfolio analysis tool once logged in to your HL account.
• Rebalance your portfolio – rebalancing should happen once or twice a year and it’s about restoring the original weightings of the investments in your portfolio. You can rebalance by adding any tops up or re-directing any regular saving instructions to areas which have become underweight. Or, by selling investments in areas that have performed well and reinvesting into areas that might not have performed so well.
• Invest into funds – funds offer an easy and convenient way to invest, popular with novice and experienced investors alike. They’re a collection of investments chosen and run by a fund manager, so you benefit from the knowledge, skills and experience of a professional. Funds invest in a range of different investments so the risk is spread around.

Need some ideas?

Our investment research team have put together some investment ideas to help you get started, but they’re not a personal recommendation to buy.

Mixed investment funds can be a great way to spread money across lots of shares and bonds – helping achieve greater returns with a relatively-lower level of risk.

For investors prepared to accept more risk, small and mid-sized companies funds can offer you an adventurous, but higher risk, way to grow your wealth.

Investing in funds isn’t right for everyone. Before investing it’s important to check the fund’s objectives align with your own, understand the fund’s specific risks and if there’s a gap in your portfolio for that type of investment.

Remember, funds go down as well as up in value, so you could still get back less than you put in.