Small cap is a shorthand way of describing the stock of a company whose market value or "capitalization"—calculated by multiplying share price by the number of shares outstanding—is small relative to other publicly traded companies. While different brokerages, funds and indexes use different definitions and ranges, small cap generally refers to companies with market values below $500 million.

Why does this matter?
Because diversification is a key principle of smart investing. Diversifying means spreading your investments both among different asset classes—stocks, bonds and cash—and within each class. Having a mix of small, mid and large cap stocks or stock mutual funds in the stock portion of your portfolio can help you manage risk. Although small caps may offer the potential for growth, they tend to be less established and more volatile than large cap or mid cap stocks.

Be wary of microcap stocks.

These are the stocks of very small companies that have market capitalizations of $50 million or less—sometimes much less. Many microcap companies are too small to meet the minimum listing standards of major stock exchanges and do not file reports with the Securities and Exchange Commission. As a result, it can be challenging to find reliable, publicly available information about a microcap company and its financial condition.