Understanding Small Cap Funds

Some stock mutual funds are characterized by the market capitalization of the companies whose shares they own. Market capitalization is the value that the stock market assigns to a company, derived by multiplying the stock price by the total number of shares.
For example, if a particular company’s stock has a current price of $42 per share, and 10 million shares of stock are held by investors, the company’s market capitalization would equal $42 10 million = $420 million. Theoretically, this is the purchase price to buy all the shares of the company on the open market.
A small cap fund specializes in companies with a relatively small market capitalization — usually below $1 billion. Some small cap funds focus on start-up companies, often in new or emerging industries such as high technology. Others focus on established companies that have plenty of room for growth. Office Depot, the popular chain of office supply stores, is a current example of a growing small cap company. The smaller firms whose stock is owned by a small cap fund can be very profitable investments, but they can also be risky. If the company managers make a few mistakes — expanding too quickly, for example, or sinking too much money into an unproven technology — the firm may go bankrupt. Thus, the manager of a small cap fund needs to have a shrewd sense of business judgment in order to separate the truly promising small firms from those that are shaky.
You may want to put a portion of your investment money into a small cap fund — but not all of it. For example, if you invest 20% of your savings in a small cap fund, you have the opportunity to enjoy rapid growth if the fund does well, without running the risk of losing your whole retirement or college portfolio if the fund runs into bad luck.