Are Basic Financial Models About to Blow Up?
Financial investment theory has a few very basic sacred beliefs. One of them is that more risk brings more reward. Study after study prove that stocks outperform bonds, and that small cap stocks outperform them all.
Studies prove this. Study after study proves this.
But what if those studies are wrong? After all, they always include the last 15 years and I believe that the last 15 years were an anomaly. In many ways, the last few years favored small cap stocks. The rise of the internet created the ideal conditions for small cap stocks. Traditional barriers to entry were destroyed overnight. Small companies could form connections a lot faster. Access to customers became easier.
This is when small cap stocks became the monster stocks of today: Cisco, Dell, Google, Yahoo, Ebay, Amazon, and so on.
In essence, the last few years were the golden age for small companies.
What if those days are over? After all, as far as I can tell, we've wrung out almost all the gains in the supply chain.
Is it possible that if we take out the internet age, small cap stock returns are actually less rewarding for their risk? That would shatter quite a lot of investing approaches.
The reason that I raise this is that I had the chance to review someone's investment portfolio. Their adviser had 50% of their portfolio in micro-cap stocks, far too many of which were housing related. naturally, they were down ~50%+ for the past year.
In speaking with the financial planner, I was told that I shouldn't worry. I should take the long-term view because, after all, the small cap stocks always generate the best returns.
Needless to say, I left shaking my head. I don't blame the investment advisor for buying into the theories that call for a better reward for small cap stocks. It's certainly worked. What bothers me is that this seems to remove responsibility for picking dumb sectors. Why buy into the housing sector last year when it was so obvious that it was crashing?
And, frankly, I question the entire premise. Maybe small caps have had their heyday, and the risk isn't offset by the reward.
I tend to avoid small cap stocks because of the liquidity problems and the potential for radical manipulation. Also, they are the first ones to suffer in a slowdown.
Studies prove this. Study after study proves this.
But what if those studies are wrong? After all, they always include the last 15 years and I believe that the last 15 years were an anomaly. In many ways, the last few years favored small cap stocks. The rise of the internet created the ideal conditions for small cap stocks. Traditional barriers to entry were destroyed overnight. Small companies could form connections a lot faster. Access to customers became easier.
This is when small cap stocks became the monster stocks of today: Cisco, Dell, Google, Yahoo, Ebay, Amazon, and so on.
In essence, the last few years were the golden age for small companies.
What if those days are over? After all, as far as I can tell, we've wrung out almost all the gains in the supply chain.
Is it possible that if we take out the internet age, small cap stock returns are actually less rewarding for their risk? That would shatter quite a lot of investing approaches.
The reason that I raise this is that I had the chance to review someone's investment portfolio. Their adviser had 50% of their portfolio in micro-cap stocks, far too many of which were housing related. naturally, they were down ~50%+ for the past year.
In speaking with the financial planner, I was told that I shouldn't worry. I should take the long-term view because, after all, the small cap stocks always generate the best returns.
Needless to say, I left shaking my head. I don't blame the investment advisor for buying into the theories that call for a better reward for small cap stocks. It's certainly worked. What bothers me is that this seems to remove responsibility for picking dumb sectors. Why buy into the housing sector last year when it was so obvious that it was crashing?
And, frankly, I question the entire premise. Maybe small caps have had their heyday, and the risk isn't offset by the reward.
I tend to avoid small cap stocks because of the liquidity problems and the potential for radical manipulation. Also, they are the first ones to suffer in a slowdown.
posted by Andrew at
8:01 PM
4 Comments:
Very interesting Andrew. Thanks for being one step ahead and always challenging the status quo. I myself was contemplating some small cap stocks now that the large caps seem to be doing nothing. But you are right, in a recessionary environment it is best to stick with large caps given their exposure. The time for small caps will come, but as you say it may not be right now.
Can you please post some analysis of past recessions and performance of small caps and when would be a good time to get in?
BTW what is your opinion of Motley Fool and their small cap stock advice?
I believe the basis for small-cap (and value weighting) for higher returns is the paper by Fama and French "Common Risk Factors in the Returns on Stocks and Bonds" published in 1993. So, the theory predates the late-90's boom, but I think people have come to expect a a much larger difference in returns than will be realistic over the long-term.
I haven't read Motley Fool's small cap stock advice. But there are tons of research papers written about the risk/reward trade-off and how small caps are proof of this.
I would like to see that same analysis done but exclude the period 1994-2008. I suspect that the risk/reward is not as good as folks expect. Also, heading into a recession, I don't think small cpas will do well except as potential merger candidates.
Small Caps and biotechs can cause cancer in your trading account. I think individual traders should not go anywhere close to these things
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