Emerging Market...'s  Instablog

With big potential comes big risk, though. As said, small caps typically represent younger, less established companies, and, needless to say, many more of these companies are destined to become the next Atari than the next Nintendo. The image of an investor breaking the bank on the latest "sure thing" to flop is just as common as that of an investor making a killing off a wise speculation. What can one do to protect their investment while speculating in small caps?

One way to go is to invest in small-cap exclusive mutual funds. It is popularly thought, although perhaps not universally true, that, on average, small caps outpace large caps over time. If that's true, then investing in a range of small caps via a small-cap exclusive mutual fund should be more lucrative than investing in large-cap funds, and investing in a fund, of course, has the benefit of protecting one from the failure of any one of the companies represented by the fund.

Of course, at the same time, the flip side of investing in a fund is that the failures of companies represented by funds drags down the gains to be had by the successes of the other companies. Small-cap funds are stable, but they do not have the potential for exorbitant success. Therefore, many investors still seek to speculate in individual small caps.

Investment guru John Wilkinson provides some suggestions that may help such a person, saying investors should avoid "the seven deadly sins." Talented professional traders, says Wilkinson, do not give in to "greed, lust, envy, laziness, gluttony, pride and vengeance." What does this mean?

For one thing, what we have just said: Spread your money around, not only in small-cap funds but, also, in other types of stock and funds. Greed is wanting too much of a good thing, and those who put all of their capital in one thing risk losing it all. Good investors have to avoid this kind of temptation.

Once your portfolio is diversified, though, you will still want to wisely pick the right individual stocks. Wilkinson's "seven deadly sins" metaphor indicates, for instance, that investors should avoid lust-the desire to invest in something that simply looks too good to be true, as most such things turn out to be just that, that is, not true.

As may already be clear, Wilkinson's argument is, in sum, to avoid investing on emotion. Good investors do their research and make decisions based on sound analytical judgments, not hunches about "what feels right."

Many investors seeking big gains look to small-cap stocks. Definitions vary, but "small cap" typically refers to stocks with market capitalizations of between $300 million and $2 billion. These stocks oftentimes represent smaller, fledgling companies, and an investor who buys a large stake in such a company does so with the hope that the company will take off, thus making the investor a large sum of money. Large caps, by contrast, cannot promise such exponential gains; they are stable, to be sure, but their growth is more likely to be steady than marked.

With big potential comes big risk, though. As said, small caps typically represent younger, less established companies, and, needless to say, many more of these companies are destined to become the next Atari than the next Nintendo. The image of an investor breaking the bank on the latest "sure thing" to flop is just as common as that of an investor making a killing off a wise speculation. What can one do to protect their investment while speculating in small caps?

One way to go is to invest in small-cap exclusive mutual funds. It is popularly thought, although perhaps not universally true, that, on average, small caps outpace large caps over time. If that's true, then investing in a range of small caps via a small-cap exclusive mutual fund should be more lucrative than investing in large-cap funds, and investing in a fund, of course, has the benefit of protecting one from the failure of any one of the companies represented by the fund.

Of course, at the same time, the flip side of investing in a fund is that the failures of companies represented by funds drags down the gains to be had by the successes of the other companies. Small-cap funds are stable, but they do not have the potential for exorbitant success. Therefore, many investors still seek to speculate in individual small caps.

Investment guru John Wilkinson provides some suggestions that may help such a person, saying investors should avoid "the seven deadly sins." Talented professional traders, says Wilkinson, do not give in to "greed, lust, envy, laziness, gluttony, pride and vengeance." What does this mean?

For one thing, what we have just said: Spread your money around, not only in small-cap funds but, also, in other types of stock and funds. Greed is wanting too much of a good thing, and those who put all of their capital in one thing risk losing it all. Good investors have to avoid this kind of temptation.

Once your portfolio is diversified, though, you will still want to wisely pick the right individual stocks. Wilkinson's "seven deadly sins" metaphor indicates, for instance, that investors should avoid lust-the desire to invest in something that simply looks too good to be true, as most such things turn out to be just that, that is, not true.

As may already be clear, Wilkinson's argument is, in sum, to avoid investing on emotion. Good investors do their research and make decisions based on sound analytical judgments, not hunches about "what feels right."

Although definitions vary, most brokerages consider small-cap investments to be stocks with market capitalizations of between $300 million and $2 billion. The investments are oftentimes viewed as attractive because of their perceived potential for high yield. The old adage, "No pain, no gain" is appropriate here: Because small-cap stocks represent smaller, frequently fledgling companies, the investor in small caps runs the risk of seeing his or her investment evaporate along with an unstable company. On the other hand, these companies present the potential for growth, and with growth comes large gains. Often, small-cap as opposed to large-cap companies are more likely to invest their earnings in expansion as opposed to other concerns. Large-cap stocks, on the other hand, are seen as representing a more stable investment-but one with less potential for exponential growth. You know your stock in a large multinational will likely always be valuable, but you also know that its increase in value is likely to be more steady than marked. The contrast is encapsulated in the popular idea of getting rich off of just the right small-cap stock or fund-in short, making a killing by picking up a small cap just before it becomes a large cap.

Is this conventional wisdom accurate, though? Perhaps not, according to respected analyst John C. Bogle, author of Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor. Bogle's data suggests that small caps oftentimes do outperform large caps-but not consistently so. Instead, their performance has been cyclical. As Bogle writers,

From 1925 through 1964 - a period of fully 39 years - small caps and large caps provided identical returns. Then, in just four years, through 1968, the small-cap return more than doubled the large-cap return. Virtually that entire margin was lost during the next five years. By 1973, small caps were about at part with large caps for nearly the full half-century. The small caps' reputation was made largely during the 1973-1983 decade. Then, perhaps inevitably, RTM (reversion to the mean) struck again in a fifth cycle. Paralleling the observation of the poet Thomas Fuller in 1650, it was darkest for the large caps just before the dawn, for the sun has shone brightly upon them since 1983.

These recent years have featured balanced small- vs large-cap performance. Given these variable returns, Bogle concludes that "In any event, the relationship between large caps and small caps, if not entirely dominated by RTM, is permeated with the force of market gravity."

Bogle's analysis may suggest that the conventional wisdom is more myth than fact. That said, whereas it might be argued that recent diminished returns for small caps suggests that increased publicity for them has leveled the playing field, the intermittent focused success of small caps during shorts periods suggests that the potential is always there. The investor can hope that he or she is on the brink of another strong period for small caps. Therefore, lessened attention to small caps is not necessarily warranted. Moreover, the need for a diversified portfolio will always dictate that a healthy amount of investment in small caps will be necessary.

Small vs. Large Caps: Does Investing in Small Caps Lead to Higher Returns?

Although definitions vary, most brokerages consider small-cap investments to be stocks with market capitalizations of between $300 million and $2 billion. The investments are oftentimes viewed as attractive because of their perceived potential for high yield. The old adage, "No pain, no gain" is appropriate here: Because small-cap stocks represent smaller, frequently fledgling companies, the investor in small caps runs the risk of seeing his or her investment evaporate along with an unstable company. On the other hand, these companies present the potential for growth, and with growth comes large gains. Often, small-cap as opposed to large-cap companies are more likely to invest their earnings in expansion as opposed to other concerns. Large-cap stocks, on the other hand, are seen as representing a more stable investment-but one with less potential for exponential growth. You know your stock in a large multinational will likely always be valuable, but you also know that its increase in value is likely to be more steady than marked. The contrast is encapsulated in the popular idea of getting rich off of just the right small-cap stock or fund-in short, making a killing by picking up a small cap just before it becomes a large cap.

Is this conventional wisdom accurate, though? Perhaps not, according to respected analyst John C. Bogle, author of Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor. Bogle's data suggests that small caps oftentimes do outperform large caps-but not consistently so. Instead, their performance has been cyclical. As Bogle writers,

From 1925 through 1964 - a period of fully 39 years - small caps and large caps provided identical returns. Then, in just four years, through 1968, the small-cap return more than doubled the large-cap return. Virtually that entire margin was lost during the next five years. By 1973, small caps were about at part with large caps for nearly the full half-century. The small caps' reputation was made largely during the 1973-1983 decade. Then, perhaps inevitably, RTM (reversion to the mean) struck again in a fifth cycle. Paralleling the observation of the poet Thomas Fuller in 1650, it was darkest for the large caps just before the dawn, for the sun has shone brightly upon them since 1983.

These recent years have featured balanced small- vs large-cap performance. Given these variable returns, Bogle concludes that "In any event, the relationship between large caps and small caps, if not entirely dominated by RTM, is permeated with the force of market gravity."

Bogle's analysis may suggest that the conventional wisdom is more myth than fact. That said, whereas it might be argued that recent diminished returns for small caps suggests that increased publicity for them has leveled the playing field, the intermittent focused success of small caps during shorts periods suggests that the potential is always there. The investor can hope that he or she is on the brink of another strong period for small caps. Therefore, lessened attention to small caps is not necessarily warranted. Moreover, the need for a diversified portfolio will always dictate that a healthy amount of investment in small caps will be necessary.

Emerging Markets Consulting
James S Painter III
WWW.EMERGINGMARKETSLLC.COM