It is January, and that means a parade of financial experts giving their personal opinions — I mean predictions — regarding the new year.
Almost inevitably, one will say that this will be a year where small cap stocks outperform the big ones: that buying stock in relaticely small companies will make you more money than a nice, diversified S&P 500 or Dow 30 index fund. I have listened to this claptrap for a half dozen years now. Here is why it is still wrong.
First, investing in small cap stocks is a dicey game of cat and mouse for small investors. Doing it sucessfully depends on finding a small company that is publicly traded, and hoping some fund manager finds it and buys large quantities of it later, driving up the value of the shares. Oh yes, it also depends on your finding this needle in a haystack without being played by some pump and dump scammer, who tells you that XYZ Corp is the up and coming thing shortly after buying it himself, and sells it shortly after enough foolish people buy it so as to drive up the price.
The second flaw in the “year of the small cap” theory is the chart they will toss up in their defense. It will be a chart of a stock index called the Russell 2000. Russell takes the 3000 biggest cap companies, calls the top thousand a big cap index, and the lower 2000 a small cap index. The first problem with this is that there are over 6000 publicly traded companies, meaning there are 3000 companies smaller than any of those in the Russell 2000.
But wait, there’s another problem with the Russell 2000, and it has to do with being the bottom 2000 of the top 3000. There are two separate schools of stock market thought that say nothing more than Newton’s first law of motion: things tend to keep going the way they are going. Both Momentum Traders and Technical Analysis adherents will tell you that stocks going up are likely to keep going up, and stocks going down are likely to keep going down, although they differ substantially on the details.
Stocks in the Russell 2000 that do well gain market cap, and graduate to the Russell 1000. On the other hand, stocks in the Russell 1000 that do poorly drop in market cap and end up in the Russell 2000. If I were designing an index to decline, it would look a lot like this. It might well go up short term, as it did in 2003, but do not get to thinking the Russell 2000 is a long term investment.
Remind me to republish this post next January.