Hi rjb112,
What works on Wall Street is not constant. That’s why the super quants who currently run the most successful Hedge funds are so secretive about their methods and must use the highest speed computers to find and to exploit the market inefficiencies.
Folks have been learning this investment lesson forever. Jesse Livermore never revealed his secrets and continuously revised them based on present conditions.
In 1996, James O’Shaughnessy wrote a book titled “What Works on Wall Street” after much research. It was celebrated as the most influential investment book over decades. When O’Shaughnessy initiated a mutual fund to put his findings into practice, it failed miserably. He sold the fund, and the methods he discovered generated excess returns for a period thereafter. Investment strategies come and go and often return. These things are highly transient.
Risk and reward are tied at the hip, but with a bungee cord so that departures in time and space are variable and unpredictable. But the cord does exist. It is captured in the Wall Street rule of a regression-to-the-mean.
Each investor gets to choose his own risk level. As Ben Franklin said: “He that would catch fish, must venture his bait”. More recently, Nassim Taleb observed: “Risk taking is necessary for large success – but it is also necessary for failure”. You get to pick where on the risk spectrum your portfolio is positioned.
There are no free lunches. The marketplace is not a perfect measuring machine and is never in equilibrium. Markets move in that ideal direction, but never quite get there. Some exogenous event disrupts the process. Physically, it’s like an agitated coiled spring that is slowing down to an equilibrium, but gets an unexpected push. Opportunities present themselves but are extremely transient. Hard work is the price to identifying opportunities.
Two themes that run throughout Scott Patterson’s excellent book “The Quants” are the secret, competitive nature of its participants, and the need for hypersonic speed. The market pricing dislocations don’t persist. For these wiz-kids, The Truth is an elusive target. Emotions are high and disaster is always near, especially when excessive leverage is deployed to magnify small percentage profits into outsized wealth.
Many long-term players say investing is conceptually easy, but difficult to execute. When David Swensen was writing “Unconventional Success”, he changed the entire format of his book to advocate an Index approach when he realized that the average investor had neither the time, knowledge, or resources needed to execute the strategies deployed by successful professionals.
In the business world size does matter.
A reasonable analogy is the human lifecycle. A vibrant adult (a mature business) is better equipped to endure and survive “the slings and arrows of outrageous (mis)fortune” than a baby (an upstart business).
Again, historically investment asset classes do have a pecking order in terms of expected returns with anticipated risk factors. Typically, but not always since the marketplace can be wild and illogical for excruciatingly long periods, Small Cap rewards are expected to outdistance Large Cap returns. The historical data generally supports this proposition.
Although Small Caps are often expected to deliver about 2 % incremental returns over their Large Cap brethren, current investor perceptions that are both factually and emotionally driven do distort these projections. Why?
Small size often makes the company more vulnerable to unexpected perturbations. Typically their product line is more focused and not as diverse as a Large firm. Another risk factor is that growing businesses are often not geography dispersed. Their marketing is regional, not international, so localized disturbances more directly impact their sales.
The accessible funding line for these smaller outfits is more fragile with lower reserves and less access to loans and at higher interest rates when they can be secured. Large companies have survived their growing phase and are more stable; smaller firms are more subject to business model failures and exogenous disruptions (a new competitor or invention) with bankruptcy a higher probability.
The bottom-line is that the old investment saw of “Diversification, diversification, diversification” is operative with respect to business sizes. Smart large businesses have the resources to do it, small businesses do not.
The equity marketplace recognizes these small organization frailties in the risk-reward tradeoffs. Standard deviation is one incomplete measure of risk that is easily available for all stocks.
An example of the market’s pricing sensitivities is to compare the Vanguard S&P
500 Index (VFINX) with the Vanguard Small Cap Value Index (VISVX) funds. My comparison dates to 1998 which is the first year of operation for the Small Cap Value fund. Here is a Link to that data set:
http://quotes.morningstar.com/fund/visvx/f?rbtnTicker=Ticker&t=VISVX&x=0&y=0&SC=Q&pageno=0&TLC=Since VISVX inception, it has cumulatively outperformed the S&P
500 Index. From the Morningstar’s chart, VISVX has turned an initial $10K investment into $39.6K while the large cap S&P
500 produced $23.6K.
Given the wild rides of the marketplace, this ordering of outcome will not persist for all specific timeframes. One thing is certain; change will happen.
Once again historically, the marketplace belonged to Mom and Pop investors. Now, professional players dominate the landscape. Indexing was nearly nonexistent early-on. Now it is 30% of the investment funds (about half professional and half Mom and Pop). Vanguard now controls more money than does Fidelity. Sea changes are not uncommon in the investment world, so an individual investor must always be alert.
Investment opportunities quickly fade. The speed needed to take advantage of these opportunities almost always takes the individual investor out of the ballgame. Even Hedge funds suffer this fate. But some general principles remain like diversification and reversion-to-the-mean.
I hope this helps. Enough pontificating. Thanks for giving me the chance to do so.
Best Wishes.
