smallinvestment.jpgA remarkable number of investors are deeply concerned about the size of the company to invest in. Unfortunately, unlike some other kinds of prejudices, not having a prejudice about size is not good. Let me explain. A few days ago I was talking to (or rather, I was being talked to) by a group of very enthusiastic investors. These were people who had dropped in to extract investment advice from me, despite my strong protestations that I had no advice to offer about any specific stocks.

However, it did not really matter because what they were interested in was displaying the high quality of the research that their brokers had provided them with. This research consisted, in its entirety, of a list of stocks that were about to go up. No actual reasoning and logic accompanied the list. In the olden days of the stock markets, this kind of research went under the term ‘tips’ but it has been re branded now

Anyway, one of things that struck me about the research-led investment strategies that they were discussing was the utter lack of any consideration for size. They consider the stock of a large company, with a high market value, and that of a company with a lower market value as alternatives to each other. This is so because the ‘research’ they are going by says that all these are likely to rise. This is deeply misguided way of evaluating stocks.

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It is one of the cornerstones of investing in stocks that large companies are fundamentally different from small companies. There are a number of basic differences that are usually there. Most of these differences become important when there is a decline, either in the general market, or in the specific company that you’ve invested in. When things turn downwards, small companies’ share prices decline more than those of large companies do. Moreover, small companies’ shares are far more illiquid than that of large companies. When you go to sell them, it is entirely possible that there is no one willing to buy, or that they have a high impact cost, meaning that the very act of offering for sale even a modest quantity pushes the price down.

Impact cost works in both directions, meaning that it’s pretty easy to rig a price upwards and create illusions. Even at the level of fundamentals, there are differences. A far larger proportion of small companies’ go into a terminal decline, that is, things turn bad for them and they never recover. Because few small companies are being intensively researched bad news can be kept well-hidden far more easily and for far longer. All these factors are well-known to serious but are routinely ignored by casual investors. In fact when considering an investment, casual investors do not even bother to find out how large a company is, sometimes they display no awareness of the fact that companies have a characteristic called size.

I’m not saying that no one should ever invest in small companies. All I’m saying that no matter what else, the risks are inherently higher and the care needed to make decisions inherently more. It also true that good small companies are supposed to provide far higher returns than large companies but the hit rate is going to be low and there’s nothing that you can do about it. Small companies need to be taken in small doses, with a strict upper limit on what proportion of your money is invested in.

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