The cautious or intelligent/strategic investor is like a general. They know which battles to pick and which pieces of high ground to hold. Whether is Gettysburg or Waterloo, the placement of troops was vitally important to the outcome of the conflict. Think of the troops as stocks, the high ground as safe investments and the battles as risks. A canny general knows they cannot win by only holding onto the high ground, but they also know that if they commit too much to the battle they could lose everything.
Diversification is essential for small cap investors. Companies with a single product or service and who have a relatively small value on the stock market, are more prone to fluctuating gains and losses in the markets. The performance results of the company during each quarter has a large effect on the value of the business. This means there is more chance of higher gains (victory) and also bigger losses (defeats). This is why investment portfolios include a mixture of large and small cap investments. Any losses in the small cap investments are offset by predictable yet modest gains from the large cap stocks.
Beware of super brands like Apple. It is right to state above that large cap stocks can act as a good balance against the unpredictability of small cap investments. They tend to remain stable over long and short periods and tend to be better placed to absorb the kinds of problems explored in our article on creative destruction. When seeking balance, however, investors need to know about the impact a large company can have on a single market.
Large brands like Apple have an influence on the market almost akin to the sun�s influence on the solar system. The S&P 500�s fourth quarter earnings for the 2011-2012 financial year showed an overall gain of 6 percent. This looks good for the overall market except for the fact that 50 percent of the growth comes directly from Apple. Another 30 percent came from AIG. This means that two companies accounted for 80 percent of the whole stock market�s profits in one financial quarter.
This can be both good and bad for a small cap investor. Let�s say an investor puts money into the stocks of some small cap companies in the S&P 500. Apple and AIG then post profits. This might drag up the share values of other S&P 500 companies, particularly those in the same industries as Apple and AIG. However, if either of those companies were to post significant losses, then a sneeze by the big company is likely to be a full-blown cold for the smaller ones. This is an extreme scenario. If Apple continues to grow, even modestly, it will help to stabilize the S&P 500 as a whole.
Riding a big company�s wave is like skateboarding while holding onto a bus. The ride can be good, but if you crash it is going to hurt. Therefore, when looking to diversify your small cap stocks look to other sectors, other stock markets and other countries. For example, specializing in technology stocks is great, but think about peripheral companies that might be affected by technology stock performances or who might be isolated from them. You want a knock on effect to aid certain stocks and you want isolation to protect other investments if things go sour. For example, make your main investments in small cap silicon valley start-ups, but keep stocks in a�courier service�or insurance company for good measure.
One place to look is the emerging markets. According to Standard and Poor, emerging market small cap companies having been continuously outperforming their developed world counterparts for a decade. They have also been beating large and mid-cap emerging markets from the same overall markets. Small cap stocks have been rising by an average of 16.6 percent over the decade compared to 13.2 percent for larger companies. This should not surprise anyone as small cap investments have been outperforming large cap investments on every continent.
This asks the question of why large investment funds are not investing in small cap companies and especially those from emerging markets. The simple answer is that large funds are not doing their research and work from approved lists. This has created a whole corner of the market for canny investors to exploit. Private investors will find the lack of attention from big funds makes it cheaper to buy stocks in markets such as Vietnam, Philippines and Indonesia.
As a result of these developments in emerging small cap markets, investors are able to diversify within small cap investments as well as between big and small cap companies. Similar prediction models for developed market small caps can be applied to emerging market ones, but it is important for international investors to pay attention to local investors who know the markets better.
It is also worth remembering that no matter how diversified a stock portfolio is, it cannot eradicate all risk. The very nature of investing means that there is always an element of risk. Too much diversification is also a potential problem. A well balanced portfolio, by common consensus, contains 20 stocks. Warren Buffet and others believe that too many stocks leads to or is on account of market ignorance. It also means that the contentious investor will find their attention too spread out to concentrate and properly research the investments they do have.
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