Stepping into the world of investing can feel like a lot like starting a new hobby. It's exciting, but you've got a lot to learn. Like any hobby, you need to get the basics down first. It's about understanding what the different concepts mean for your money.
You may have come across the term 'market capitalisation' or 'market cap'. We'll get into its meaning more deeply soon, but as a precursor, market capitalisation helps you quickly figure out how big a company is in the stock market. It's a clue to identify the big fish and those that are still growing.
By the end of this article, you'll hopefully see why knowing about market cap is important for your long-term investing journey. You'll also ideally know how you can use this knowledge to build your portfolio.
What is market capitalisation?
When you first hear the term 'market capitalisation', it might sound like a complex financial concept. But it's not as complicated as it seems.
Some investors initially think market cap is about ranking a company's success. It's more about the size of a company in the stock market, not its performance. Understanding market cap does involve crunching some numbers, but once you do, you can form an idea of the bigger picture.
So, let's take a step back and simplify it.
Imagine you’re in a market, but instead of buying fruit or veggies, people are buying and selling portions of companies. These portions, as you may have guessed, are called shares . Market cap is the total market value of all those shares. It's calculated by multiplying the number of shares outstanding by the price of a single share. This doesn't necessarily tell you how much the company is worth. But it does help you figure out how big a company is in the stock market.
Market cap helps sort companies into different sizes like small cap, mid cap, and large cap. Small cap companies are like the small fish in the big pond. Large-cap companies? They're the big fish, the major players in the market. And, naturally, mid cap companies sit somewhere in between.
Why is understanding market capitalisation important?
Market cap isn't only used for regular shares. It’s also used for cryptocurrencies and ETFs (Exchange-Traded Funds) . For ETFs, market cap can help a fund manager decide which companies to include and how much weight they have in the fund.
Stock market indexes, like the ASX 200 or the Dow Jones , also use market caps. It helps determine which companies are big enough to include in the index.
Market cap is also important in the domestic equity market – or the stock market in your own country. It helps you understand the total dollar market, like how much value is in a market or a segment.
Now, a higher market cap doesn’t always mean a company is better. It’s like saying a bigger shop is always better than a smaller one. Not necessarily true, right? Even so, larger cap companies tend to be established and experience more stable performance.
Remember, the total number of shares and the share price can change, so the market cap isn't static. It’s always shifting, just like the market. Getting your head around this concept is a great step in understanding the current market share and where you might want to put your money.
Market capitalisation example: Kangaroo Kicks
Let's look at a fictitious example to understand market capitalisation.
Kangaroo Kicks is a fictional Australian company that manufactures sports shoes. Now, Kangaroo Kicks has issued a total of 10 million shares in the market – these are the 'outstanding shares'. The current price of a Kangaroo Kicks share is $25.
To figure out the market cap of Kangaroo Kicks, we multiply the share price by the total number of shares. So, it's $25 (share price) x 10 million (outstanding shares). This gives us a market cap of $250 million. That's the total value of Kangaroo Kicks in the stock market.
This example is super simple, but that's essentially how market cap is calculated. Remember, this isn’t about how good Kangaroo Kicks is as a company or its total asset figures. It's a way to measure its size compared to other companies in the market. Kangaroo Kicks, with a market cap of $250 million, might be considered a small-cap company.
What is the role of market capitalisation on shares and ETFs?
Sure, understanding market cap can help know a company's value in the stock market. Beyond that, though, it can also help you spot opportunities and avoid risks based on company size and experience.
Let's explore how market cap can play a role in the world of shares and ETFs.
Imagine a company as a big pie, and this pie is divided into slices called shares. The price of each slice (share) can go up and down based on how much people are willing to pay for it. This is the 'share price'. As we said above, market cap is the total value of all the pie slices put together.
So, what happens if the share price changes? Well, if the share price goes up, the total value of all the shares (a.k.a market cap) also increases. On the flip side, if the share price drops, the market cap decreases too.
T his applies to both individual shares and ETFs , which hold a collection of individual shares from different companies. Now let's break it down further:
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Market cap size:
Market cap helps to sort companies into categories like large cap, mid cap, and small cap.
Large cap companies are the big players in the market. They're the heavyweights – more established and usually less risky (although there are always exceptions, so do your research!). Investing in large cap stocks has historically equated to choosing a more stable path. They might not grow rapidly but they're less likely to take a sudden dive.
Small-cap companies are at the other end. They can be riskier to invest in because they’re not as established, but they also have more room to grow. Investing in small cap stocks is like backing a new runner in a race – there’s a chance for big wins, but also a big risk of losing out.
Mid-cap stocks sit in the middle. They offer a balance between the potential growth of small caps and the stability of large caps. - Risk and return: In investing, you're obviously aiming for a return down the road . Generally, the larger the market cap, the lower the risk, and vice versa. Large cap stocks might generally offer steadier returns, while small caps can swing up or down more dramatically.
- Liquidity: Liquidity is about how easy it is to buy or sell ETFs (or shares) without affecting their price. Large cap stocks tend to be more liquid. On the other hand, small cap stocks can be less liquid — like a small pond where every movement is noticeable.
Whether you're looking at common shares on the stock exchange, or want to invest indirectly through ETFs, understanding market cap helps you estimate the size and potential risk or reward. This knowledge can inform your investment decisions as part of the bigger picture.
Market capitalisation for long-term investors
How does knowing about market cap impact long-term investing strategies? When you're in it for the long haul, understanding market cap is like having a roadmap for your investment journey. It can let you in on how a company size can fit into your overall investment plan.
Additionally, market cap helps you decide the type of companies you want in your portfolio. How? Let's take a look:
- Determining portfolio allocation : Market cap helps you figure out what mix of companies to put in your investment portfolio. It's like deciding how much of your money to put into big (large cap), medium (mid cap), and small (small cap) companies. This way, you're not focusing on one type of company, but spreading your investments.
- Diversification to spread risk : Speaking of spreading your investments, diversification means not putting all your investments in one place. By having a mix of large cap, mid cap, and small cap stocks, you reduce the risk. If one type of stock doesn't perform well, the others might balance it out. So, if large cap stocks are steady but slow to grow, small cap stocks might offer quicker growth but with more ups and downs.
- Matching investment style with cap size : Your personal investment style can guide you in choosing the right market cap size. If you like a steady and more predictable investment, large cap stocks could be a good fit. They're typically well established companies with a solid position in the market.
If you're aiming for faster growth and are comfortable with more risk, small cap stocks could be a suitable addition to your portfolio. They have more potential for quick growth but can also be more unpredictable.
So, whether you’re investing in the domestic equity market or looking at global stocks, understanding market cap helps you make smarter choices. A solid understanding of market cap can lead to better decisions and a more resilient portfolio.
Market cap mastery – tying it all together
Understanding market cap empowers you to make informed investment decisions. For long-term investors, market cap assists in crafting a diversified and balanced investment strategy. By understanding the different market cap sizes, you can align your investment choices with your goals, be it stability or growth.
Mastering your understanding of market capitalisation can be your key to unlocking smarter, more strategic investment decisions. Keep this knowledge in your toolkit as you build and refine your investment strategy. You can use it help you navigate the ever-evolving financial markets.
Happy investing!
