Should you invest in small-cap ASX shares?

Investing in small-cap ASX shares can increase the likelihood of realising greater returns. Conversely, snapping up smaller stocks can increase the risks involved in investing.

So, do small-cap ASX shares deserve a place in your portfolio? Well, I can’t speak for you. Personally, however, I would consider including a few small-caps in my holdings.

What is a small-cap share?

Before we get too involved, let’s break down the definition of a small-cap.

As the name suggests, they are listed companies with smaller market capitalisations – often referred to a valuation – than the ASX’s giants.

As a rule of thumb, they have a market cap of a few hundred million to $2 billion. The S&P/Small Ordinaries Index (ASX: XSO) is often thought to be the benchmark index for small-caps.

As small-caps are small, they are also often growth shares. And therein lies the reason I would consider them for my portfolio.

Small caps can double as growth stocks

While S&P/ASX 200 Index (ASX: XJO) giants have plenty of cash and competitive advantages banked away to help them weather tough times, their potential growth is also generally limited.

Small-cap ASX shares, meanwhile, are often up-and-comers. That means investors can get in on quality companies before they make it big.

Many of the ASX’s biggest players were once tiny shares.

Fortescue Metals Group Limited (ASX: FMG) was just a penny stock in 2003, as my Fool colleague Sebastian reports. Today, it’s worth around $66 billion.

Though, not all small shares are future winners. Investing in small stocks can be riskier than investing in the big end of town, particularly as smaller companies may struggle more than their larger counterparts during hard times.

And, of course, picking future goliaths when they’re nothing but seedlings is notoriously difficult, but you’ve got to be in it to win it, in my opinion.

Beyond the growth potential on offer by small-cap ASX shares, I would consider a handful for diversification purposes.

Using small-cap ASX shares to diversify

Building a diverse portfolio can be key to navigating risk.

While risk is near-synonymous with investing, buying quality business in a variety of sectors – and sizes – can help protect one against single sector downturns and make the most of the good times.

That may mean a bit of stock picking. Though, I think the time and attention it takes to pick stocks I believe in is a small price to pay for a diverse portfolio.

However, if that were to sound like too much work, there are many ASX exchange-traded funds (ETFs) and index funds that provide exposure to many small-caps.