Why is small better?
Small stocks are being viewed as an attractive investment. An article in the Wall Street Journal discussing this trend starts in the following way: "International investors are starting to think smaller. They should have started earlier" (From: http://online.wsj.com/article/SB117486630727948482-search.html?KEYWORDS=karmin&COLLECTION=wsjie/6month).
However there are some major concerns present in the common perception of small stocks. Small capitalization securities tend to be more volatile and hence more risky. Less data is provided for such companies, due both to the fact that smaller companies cannot produce a given level of financial data, as well as, because they seem to be out the focus of most analysts. Do the given above reasons determine that small stocks are not as valuable as an investment option? Not necessarily...
TINSTAAFL... or is there?
The acronym above means, "There is no such thing as a free lunch", and is widely used in economics and finance literature. In finance, this statement applies to the fact that an investor has to bear additional risk in order to achieve a higher return rate.
Surprisingly, small stocks seem to defy this rule and provide "a free lunch" on a regular basis. Historically, small stocks have brought higher returns than big stocks. The Wall Street Journal states: "Small and midsize stocks in Europe, Japan and other corners of the developed world have offered some of the best earnings growth anywhere in recent years. These stocks returned 25% a year, on average, for the five years through December, according to Morgan Stanley Capital International. Like U.S. small-capitalization stocks, small-cap foreign stocks outperformed large-cap foreign stocks for each of the past six years. Up 7% year-to-date, foreign small stocks are ahead again this year." (From: http://online.wsj.com/article/SB117486630727948482-search.html?KEYWORDS=karmin&COLLECTION=wsjie/6month). Analyzing any kind of historical market data should lead to the same conclusion.
This characteristic might be explained by a greater risk present while investing in small caps. However, financial research and empirical evidence seems to prove that, as Robert Strong, CFA puts it, small stocks provide a higher risk adjusted rate of return. Additionally, this outcome seems to be persistent. (See: Strong, R., Portfolio Construction, Management & Protection, 4 edition, Thompson Southwestern, 2006, p.249.). This is commonly known as: "small firm effect - The tendency for firms with low levels of capitalization to perform better than finance theory suggests they should". (From: http://websites.swlearning.com/cgi-wadsworth/course_products_wp.pl?fid=M20b&product_isbn_issn=0324232586&discipline_number=414 ). Known financial researchers, Prof. Eugene Fama and Prof. Kenneth French have researched the topic in detail, one should turn to their work for further information about it.
International diversification allows achieving a level of risk, which is approximately the half of the risk borne in a well-diversified domestic stock portfolio. Well established capital markets in Europe and Japan exhibit a similar form of market efficiency as the US markets, furthermore they do know carry excess volatility of emerging markets. Investing in small caps in developed international markets seems to be a very attractive option, carrying moderate risk and a premium risk adjusted rate of return on average, when compared with the large caps. That just brings an annoying thought that the US investors should have thought about foreign small caps earlier...
Small stocks are being viewed as an attractive investment. An article in the Wall Street Journal discussing this trend starts in the following way: "International investors are starting to think smaller. They should have started earlier" (From: http://online.wsj.com/article/SB117486630727948482-search.html?KEYWORDS=karmin&COLLECTION=wsjie/6month).
However there are some major concerns present in the common perception of small stocks. Small capitalization securities tend to be more volatile and hence more risky. Less data is provided for such companies, due both to the fact that smaller companies cannot produce a given level of financial data, as well as, because they seem to be out the focus of most analysts. Do the given above reasons determine that small stocks are not as valuable as an investment option? Not necessarily...
TINSTAAFL... or is there?
The acronym above means, "There is no such thing as a free lunch", and is widely used in economics and finance literature. In finance, this statement applies to the fact that an investor has to bear additional risk in order to achieve a higher return rate.
Surprisingly, small stocks seem to defy this rule and provide "a free lunch" on a regular basis. Historically, small stocks have brought higher returns than big stocks. The Wall Street Journal states: "Small and midsize stocks in Europe, Japan and other corners of the developed world have offered some of the best earnings growth anywhere in recent years. These stocks returned 25% a year, on average, for the five years through December, according to Morgan Stanley Capital International. Like U.S. small-capitalization stocks, small-cap foreign stocks outperformed large-cap foreign stocks for each of the past six years. Up 7% year-to-date, foreign small stocks are ahead again this year." (From: http://online.wsj.com/article/SB117486630727948482-search.html?KEYWORDS=karmin&COLLECTION=wsjie/6month). Analyzing any kind of historical market data should lead to the same conclusion.
This characteristic might be explained by a greater risk present while investing in small caps. However, financial research and empirical evidence seems to prove that, as Robert Strong, CFA puts it, small stocks provide a higher risk adjusted rate of return. Additionally, this outcome seems to be persistent. (See: Strong, R., Portfolio Construction, Management & Protection, 4 edition, Thompson Southwestern, 2006, p.249.). This is commonly known as: "small firm effect - The tendency for firms with low levels of capitalization to perform better than finance theory suggests they should". (From: http://websites.swlearning.com/cgi-wadsworth/course_products_wp.pl?fid=M20b&product_isbn_issn=0324232586&discipline_number=414 ). Known financial researchers, Prof. Eugene Fama and Prof. Kenneth French have researched the topic in detail, one should turn to their work for further information about it.
International diversification allows achieving a level of risk, which is approximately the half of the risk borne in a well-diversified domestic stock portfolio. Well established capital markets in Europe and Japan exhibit a similar form of market efficiency as the US markets, furthermore they do know carry excess volatility of emerging markets. Investing in small caps in developed international markets seems to be a very attractive option, carrying moderate risk and a premium risk adjusted rate of return on average, when compared with the large caps. That just brings an annoying thought that the US investors should have thought about foreign small caps earlier...
