How to spot risk – why company size matters

Investing in the stock market is fundamentally risky business. But not all risk is equal – some companies carry more risk than others.

For investors, it’s essential to understand the companies you invest in and how they impact the balance and overall risk level of your portfolio. It’ll dictate the size and scale of the ups and downs you might face along your investing journey. We call this volatility.

Here we look at how to spot risk, and explain why company size really matters when investing in shares.

This article has information to help you manage risk, but it isn’t personal advice. If you’re not sure what’s right for your circumstances, seek financial advice.

How to spot risk

On a basic level, you can get a better understanding of a company’s risk by looking at its market value. Otherwise known as market capitalisation.

It can be a handy ‘riskometer’ for investors looking to spread their risk across companies of different sizes, or to avoid investing in high-risk areas, such as smaller companies.

Market capitalisation is simply the total number of shares in issue multiplied by the latest share price. For example, 10 million shares trading at £10 has a market value of £100 million.

Other company-specific factors will also play a role in the overall risk of investing in a company, so it’s important to look at the wider picture and fully understand the companies you invest in. Are they profitable, or loss making? Are they overburdened with debt? Do they trade in developed or undeveloped regions?

Big vs small – what’s the difference?

You might think publicly listed companies on the stock market are all the same and big names in their own right.

But that isn’t always the case.

Listed shares come in all shapes and sizes, from small, innovative start-ups to larger, well-established market leaders – there are thousands of opportunities in the investing universe.

Investing in smaller companies is riskier. Share prices move up and down sharply and can reach new highs and lows more often. As an investor, this can increase your profits if your investment does well, but also widen losses should things go pear-shaped.

Smaller companies tend to operate in up-and-coming or niche sectors. This can throw up some exciting opportunities in areas of the market that could grow faster than average. As a result, smaller companies shares are generally characterised as ‘growth’ shares.

The valuation of a growth share is largely based on profits it’s expected to earn in the future rather than today. The theory is that a company that can grow its earnings rapidly could see its share price rise faster than the average company. Investors demand a higher potential return for the extra layer of risk – which is the potential for losses if the company fails to meet investor expectations.

Smaller companies tend to have a market capitalisation at the lower end – their market value is lower. Because of their size, they’re usually more domestically focused so their fortunes are tied to the health of the local economy. This means smaller companies might suffer the most during an economic downturn.

On the other hand, large companies (sometimes called large-cap shares) boast the biggest market value. In the UK, the FTSE 100 index is a list of the 100 biggest listed companies, including the likes of Rolls Royce, Tesco and Lloyds.

Large-cap shares are often industry leaders in their field, generating profit from around the world and have stood the test of time. It can mean they’re sometimes less exciting names, but they don’t always have to be. The best investments are often boring – ones that can steadily grow profits and compound annual returns for investors over the long term.

Larger companies tend to have less opportunity to grow their existing business to increase profits and grow their share prices. Instead of capital growth, often they try to reward investors with income through dividend payments. Remember though, income from investments is variable and isn’t guaranteed.

Why size matters

The size of companies you invest in can impact your expected returns and expected volatility (the ups and downs in the value of your investments).

The below chart shows how volatility and returns can vary between shares of different sizes.

A comparison between the FTSE 100 and FTSE AIM indexes between 2001 and 2021

Past performance isn’t a guide to the future. Source: Eikon. Correct to 31/12/2021.

The Alternative Investment Market (AIM) index is made up of small and medium-sized companies. On average, shares in the index have been highly volatile (they have gone up and down in value a lot), but offered less in terms of returns for investors.

In comparison, the FTSE 100 index has been less volatile than the AIM index, but yielded higher returns, on average.

In a world where good investing is all about finding the highest possible returns for the lowest possible risk, you always have to question whether extra risk is worth it. In this case, it doesn’t seem to be.

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 history shows the stock market has been more likely to give a positive return the longer the period of investment, losing large chunks of an investment’s value in a short period of time could be difficult to recover from.

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

Investing in individual shares, especially smaller companies appeals to many investors. They can seem exciting and have a great story behind them. But the numbers tell a different story.

That’s not to say everyone should avoid them completely. 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.

Why fortune doesn’t always favour the brave

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, other areas could perform better and help pick up the slack.
• 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 top ups 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.

  A step-by-step guide to reviewing an investment portfolio

• 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. With thousands of funds available, you can invest in a mix of asset types such as shares and bonds to spread the risk around.

Two fund ideas to help manage risk

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 to 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, all investments go down as well as up in value, so you could still get back less than you put in.