Tuesday, February 28, 2012

How to Avoid Miscalculating in Small-Cap Investments

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.”

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