ETF Investing Guide: The Challenge of Trying to Pick Small Cap Stocks

In early 2003, five factors converged to offer the potential for significant appreciation in small cap tech and Internet stocks:

1. Many small cap tech companies lacked Wall Street research coverage due to cuts in banks' research departments;
2. Investors were avoiding these stocks due to fear of further losses;
3. Many small cap tech companies had strong balance sheets, and therefore limited near term risk;
4. Many small cap tech companies had become profitable or at least generated positive cash-flow;
5. Yet in many cases the stocks traded below cash.

So it made sense for investors to consider focusing their stock picking on small and micro cap technology and Internet stocks. But with the following important caveat:

As an investor, a key goal should be to diversify your portfolio and lower your risk. We’ve seen that you can successfully pick stocks if you (a) focus on the areas of maximum market inefficiency and (b) research a small enough number of stocks to give yourself an edge. But notice that then, by definition, you’ll end up with a highly concentrated portfolio of relatively illiquid and neglected securities. Not a good idea: too risky, and not suitable for the core of your portfolio. So you could invest in under-followed small cap and emerging market stocks to boost your returns and to complement your core portfolio, but certainly not to replace it.

What happened? In 2003, the Wilshire Micro-cap index rose by 92%, and since then small and microcap stocks have handily outperformed large caps.

With the dramatic rise in the indexes since 2002, small and micro cap stocks no longer seem like such a bargain. Moreover, numerous research boutiques have decided to focus on these stocks, so the information inefficiency that allows for alpha generation has likely subsided somewhat.

Most important, few individual investors had the stomach to buy small caps and microcaps when the market seemed to be falling. Individual investors seem to feel much more comfortable buying stock when they are doing well and selling them when they are doing poorly. Or in other words: buying high and selling low.

All this means that regular investors should be extra skeptical about their chances of success when picking individual stocks, even as a small adjunct to a core portfolio of index funds.

Better just to stick with the ETFs.

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