Small cap stocks can add growth prospects to a portfolio of top-performing blue chip stocks. Here are some tips on how to find the optimum balance

Top-performing blue chip stocks pair well with the best small caps because blue chips can give you an additional measure of safety in turbulent markets. The best blue chips offer both potential for capital gains growth in addition to regular dividend income. That’s why we feel most investors should hold the largest part of their investment portfolios in securities from blue chip companies.

On the other hand, the best small caps are well-established firms in growing fields, even though they may not have as secure a hold on a growing or at least stable clientele that conservative stocks have.

Incidentally, we think it’s a mistake to generalize about small cap stocks. Some small caps are junk. Others are small companies that have a history of sales and earnings, and attractive growth prospects. Others are industry leaders that have small capitalizations only because they serve a small industry.

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Top-performing blue chip stocks and small cap stocks

While we believe that investors should devote the biggest part of their portfolios to large, well-established “blue chip” securities, this does not rule out smaller stocks. Indeed, a strong portfolio anchored with blue chip stocks offers the opportunity to invest in promising smaller companies without subjecting yourself to excessive risk. And the best of these smaller companies may one day grow into blue chips themselves.

Shares of large, well-established companies generally have a market “cap” (that’s short for “capitalization,” or total value of shares outstanding) of billions of dollars. They usually rebound better than other stocks from downturns.

“Small caps” are smaller companies with a market capitalization below some arbitrary figure, such as $1 billion. They are typically more volatile—rising quickly in bull markets, but often falling quicker in market downturns, and rebounding more slowly.

Here are three ways you can spot good investments in both small capitalization and large capitalization companies:

1. Look beyond market cap to judge a company’s investment quality. Large cap stocks can be leaders in giant fields with expanding potential. Or they can be wounded behemoths in declining fields. The investment quality of small caps varies even more. They range from near-worthless promotional issues to leaders in small but fast-growing fields.
2. To tell good companies from bad, you have to look at a variety of factors much subtler than market cap. They include earnings, dividends, the strength of the balance sheet, the strength of the company’s products, customer loyalty or fickleness, and so on.
3. A large cap stock may have a high or low price per share. Remember, a company’s market cap is equal to the total number of shares outstanding multiplied by the price per share. However, a large cap stock can have a low price per share if it has many shares outstanding.

To succeed in today’s volatile markets, you’ll need to own shares in a variety of companies of varying sizes. But here’s one thing your best choices will have in common: each will be about the right size to succeed in the business it is in.

How to pick the best small caps to hold alongside your top-performing blue chip stocks

The best small cap stocks have the potential for large gains, but they are generally more volatile than large-cap stocks. Temporary setbacks, such as a poor quarterly earnings report, or the loss of a major contract, can quickly cut their share prices. That’s why we view even the best small cap stocks as aggressive investments.

To find the best small cap stocks for lower-risk gains, we recommend looking for sound companies that stand to benefit as the economy continues to improve. It’s also important for these stocks to be well established, with strong management and prominent positions in their markets.

The best small caps can offer above-average growth potential. As well, small caps, good and bad, can fall out of investor favour during periods of market volatility. When this happens, successful investors can have opportunities to buy the best small cap stocks at discounted prices.

Many investors think of the “small cap group” as the place to look for aggressive investments, such as junior companies that will develop into seniors and make huge gains for investors. Some small caps will indeed turn out that way, but you’ll need to choose carefully. That’s because small cap stocks vary widely in quality.

An investor with a longer time horizon can invest more money in small cap stocks, but we think sticking with a smaller part of your portfolio is still a good idea.

Discover top-performing blue chip stocks by using our three-part Successful Investor approach

You will have a strong selection of blue chip stocks in your portfolio when you follow our three-part investing program.

These three safeguards will tend to limit your losses at the worst of times. But over long periods, they also let you profit nearly automatically.

1. Invest mainly in well-established, mainly dividend-paying companies.
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities).
3. Avoid or downplay stocks in the broker/media limelight.

What is the proportion of large caps vs. small caps in your portfolio? Why did you set it up that way?