Stock indices give an indication of the overall level of the stock market by calculating a number based on a certain basket of stocks. A small-cap index has the same function, but it narrows its basket of stocks so that it focuses on small companies. The resulting index gives investors an idea of the performance of a particular market segment. This allows an investor to compare the movements of the small-cap stocks that he owns with the overall performance of similarly sized companies. The ability to categorize companies according to size is important because market conditions can favor one class over another, so the relative performance of an individual portfolio would be inaccurate if based on data from the whole market.
A stock index reports a number in units called points. The level is based on the market values of the stocks that make up the index. The absolute value of an index is insignificant; it is a relative measurement that makes sense only in the context of previous levels. Investors use indices to evaluate their portfolios. For example, if an investor’s portfolio stays at the same value, he has chosen stocks well if the relevant index falls by 30 percent, but he has chosen poorly if it rises by 30 percent.
A small-cap index includes only stocks with low levels of market capitalization. The market capitalization of a company is the total market value of its stock. It is calculated by multiplying the number of shares outstanding by the market value of a share. Investors commonly evaluate the size of a company by assessing the company’s market capitalization as compared to other companies.
Small-cap is a relative term: small companies are only small if there are larger companies. In 2010, small-cap generally referred to companies that had between $300 million US Dollars (USD) and $2 billion USD in market capitalization. This range changes as the companies that comprise the stock market grow; in the 1980s, a company with $1 billion USD market capitalization was viewed as a large-cap company. Even at one point in time, each small-cap index defines its own range, so there is no absolute definition of a small-cap stock.
A small-cap index can be a subset of a major stock index. For example, the Dow Jones Wilshire 5,000 index reports averages for four subsets of the main index: large-cap, mid-cap, small-cap, and micro-cap. These classifications are commonly based on the stocks’ market capitalization ranking within the list of stocks used to calculate the index. Thus, their relative size depends on the composition of the index. For example, the Dow Jones industrial index has a larger average market capitalization than Nasdaq, so the two indices will have different definitions of small-cap.