Should you buy small-cap shares instead of large-cap stocks?

Smaller companies have historically outperformed their larger peers in the long run. However if you're thinking of investing in small-cap companies, there are some things you should know. Here's a look at three key differences between smaller companies and larger firms.

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High volatility

The first and most important thing to keep in mind when it comes to investing in small-cap stocks is that they're inherently more risky than the large-cap kind. Risk equates to volatility and if you're looking to build a 'sleep well at night' portfolio, you'll probably want to limit your exposure to smaller companies.

When share market panic arises as it so often does, small-caps are often the first to be sold as investors flee to safety, and the sell-offs can be quite dramatic. Even companies with excellent prospects can lose 50% of their value in the blink of an eye.

A good example here is the contrast in falls between Lloyds Banking Group and challenger bank Aldermore Group after the Brexit vote in June. Whereas Lloyds fell around 35% in the days after the vote, Aldermore lost closer to 50%. That's a 50% share price drop for a company that grew earnings by 75% last year. Imagine what could happen to a company struggling to make a profit?

Furthermore, it's not uncommon for smaller companies to go bankrupt and when this happens, shareholders can lose their entire stake in the company. It's important to bear this in mind when investing in small-caps and only invest what you can afford to lose.

Big gains

However, the key trade-off to the higher risk is that small-cap investing can be extremely profitable. It's the combination of fast growth and less research by the market, that results in opportunities for the small-cap investor.

Take a look at the share price of identity management specialist GB Group. In October 2011 the stock was trading at 42p. Five years later it's trading at 320p, a huge 660% return. While it's not impossible to achieve this kind of return from a FTSE 100 company, it's certainly less likely.

Now obviously not every smaller company will perform like this, but if you do manage to invest in a handful of high-flying smaller stocks, your wealth really can be increased significantly in a short period.

Dividends

Lastly, a comparison of smaller and larger companies wouldn't be complete without mentioning dividends. These are an essential part of investing as many studies have shown that over the long term, dividends make up the majority of portfolio returns.

This is one area in which larger companies have an edge over their smaller rivals, as you're much more likely to receive a sizeable dividend payout from a well established mature business than you are from a start-up.

Smaller companies often reinvest their profits back into the business, focusing on long-term growth and placing less emphasis on rewarding shareholders in the short term. That's not to say you can't find smaller companies that pay dividends. They certainly do exist, but if you're looking for formidable dividend payouts, you're probably better off looking at larger blue-chip companies.

Ultimately, the decision to invest in small-cap shares comes down to the individual investor. Understand the risks of smaller companies and then construct a portfolio tailored to your personal investing goals and risk tolerance.

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Edward Sheldon owns shares in Aldermore Group. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.