I think we all suffer from it to some degree. Even though I’m focused on small caps, and want to stay focused on small caps, I can feel those forces pulling me toward large caps, and I have to actively fight them.
To be completely honest, reading your great analyses sometimes contributes to that too (I’m thinking in particular of HEICO).
"You inherit your investing universe". Thanks for sharing this great read!
You got to the root of biases that lead investors to choose their "ponds" (large cap vs small cap). Most times, it has nothing to do with risk and everything to do with comfort (what we have always known) and availability.
Most people say small caps are "too risky," but as this post points out, that’s usually the right answer to the wrong question. If you "control your junk" and filter for quality, the size premium isn't just a theory—it’s a massive edge that most active investors are too "culturally blind" to see.
Question: Do you think the perceived safety of a Large Cap name is worth the "Alpha destruction" of competing against the smartest, best-funded algorithms on the planet?
As you said, it’s all about perception (“perceived”), so from that point on it’s impossible to give a universal answer.
In my view, the best heuristic is to choose the investment approach that minimizes the likelihood of biases leading to value-destructive behavior.
For some people, the volatility and perceived risk of small caps can trigger “irrational” decisions that destroy more value than if they had simply stayed in large caps. So the answer to your question ultimately requires some serious self-reflection from each person.
While all that is convincing, i dont think its true/practical. You left out a big assumption that the investor hunting in small caps is willing and able.
There's 2 things:
1. He is willing. The work involved in small cap is generally speaking more complicated than large caps. Because the businesses are small, they are exposed to niche problems that can be difficult to sieve out. There's also special situation investing where it demands alot of deep study.
2. He is able. The analytical edge you say assumes that the investor is smart. Buffett is extraordinarily smart, he's not average intellect. You must also assume that the investor has the required training to do sharp analytical work.
So the profile of such a person would be very passionate about the job, if he is not paid good money, he must then be confident that returns % are big enough to pay for his effort, given he manages a small sum.
Further, he should be above average smart to have an edge.
Such a person will no doubt succeed, regardless if he played in large/mid/small caps. The market presents mispricing (and hence opportunities) on all types - though i agree that small caps will more likely be mispriced to a larger degree.
So, putting a quote on Buffett at the end is actually conceding to these assumptions. He is a smart and hardworking person, i would even say at an elite level, that's why he's able to get such returns. It had little to do with the pond he fished in.
Let's go with the GEICO example Buffett first bought in 1951. Everyone already knows the story, he visits CFO Lorimer Davidson and spoke to him for 4 hours.
How many people are willing/able to do that: Particularly have a meaningful conversation with a CFO for 4 hours, while still a student at CBS? It's immense talent!
Fast forward to 1976 where he assessed John Byrne and bought alot of GEICO shares near bankruptcy. Again, immense talent and knowledge at work.
Put together, I'm trying to say that it's true that more alpha is in small caps, but it's very difficult to achieve, such alpha is reserved for the very talented investor. This arena is far from the "easiest" place (as you put it). It's actually a very difficult arena.
// I quote from your post:
[[ When the goal is to generate alpha, there’s only one question to ask:
“Where do my efforts have the best chance of paying off, given the risks I take and the time I spend?” ]]
>> I think the best chance of pay off is first recognizing how much talent one has. That's the "one question" to ask.
Great point. Investors' egos forces them to try to answer the tough questions, but that isn't where the biggest expected return is
Wow great post! I think I'm suffering from large cap cultural blindness.
Thanks a lot, TPC!
I think we all suffer from it to some degree. Even though I’m focused on small caps, and want to stay focused on small caps, I can feel those forces pulling me toward large caps, and I have to actively fight them.
To be completely honest, reading your great analyses sometimes contributes to that too (I’m thinking in particular of HEICO).
"You inherit your investing universe". Thanks for sharing this great read!
You got to the root of biases that lead investors to choose their "ponds" (large cap vs small cap). Most times, it has nothing to do with risk and everything to do with comfort (what we have always known) and availability.
Thanks for the feedback!
The “upside” is that, as you imply with “we,” almost all of us are affected by this, and a bit of introspection was enough to do most of the analysis.
Hello!
Most people say small caps are "too risky," but as this post points out, that’s usually the right answer to the wrong question. If you "control your junk" and filter for quality, the size premium isn't just a theory—it’s a massive edge that most active investors are too "culturally blind" to see.
Question: Do you think the perceived safety of a Large Cap name is worth the "Alpha destruction" of competing against the smartest, best-funded algorithms on the planet?
Hi,
As you said, it’s all about perception (“perceived”), so from that point on it’s impossible to give a universal answer.
In my view, the best heuristic is to choose the investment approach that minimizes the likelihood of biases leading to value-destructive behavior.
For some people, the volatility and perceived risk of small caps can trigger “irrational” decisions that destroy more value than if they had simply stayed in large caps. So the answer to your question ultimately requires some serious self-reflection from each person.
While all that is convincing, i dont think its true/practical. You left out a big assumption that the investor hunting in small caps is willing and able.
There's 2 things:
1. He is willing. The work involved in small cap is generally speaking more complicated than large caps. Because the businesses are small, they are exposed to niche problems that can be difficult to sieve out. There's also special situation investing where it demands alot of deep study.
2. He is able. The analytical edge you say assumes that the investor is smart. Buffett is extraordinarily smart, he's not average intellect. You must also assume that the investor has the required training to do sharp analytical work.
So the profile of such a person would be very passionate about the job, if he is not paid good money, he must then be confident that returns % are big enough to pay for his effort, given he manages a small sum.
Further, he should be above average smart to have an edge.
Such a person will no doubt succeed, regardless if he played in large/mid/small caps. The market presents mispricing (and hence opportunities) on all types - though i agree that small caps will more likely be mispriced to a larger degree.
So, putting a quote on Buffett at the end is actually conceding to these assumptions. He is a smart and hardworking person, i would even say at an elite level, that's why he's able to get such returns. It had little to do with the pond he fished in.
Let's go with the GEICO example Buffett first bought in 1951. Everyone already knows the story, he visits CFO Lorimer Davidson and spoke to him for 4 hours.
How many people are willing/able to do that: Particularly have a meaningful conversation with a CFO for 4 hours, while still a student at CBS? It's immense talent!
Fast forward to 1976 where he assessed John Byrne and bought alot of GEICO shares near bankruptcy. Again, immense talent and knowledge at work.
Put together, I'm trying to say that it's true that more alpha is in small caps, but it's very difficult to achieve, such alpha is reserved for the very talented investor. This arena is far from the "easiest" place (as you put it). It's actually a very difficult arena.
// I quote from your post:
[[ When the goal is to generate alpha, there’s only one question to ask:
“Where do my efforts have the best chance of paying off, given the risks I take and the time I spend?” ]]
>> I think the best chance of pay off is first recognizing how much talent one has. That's the "one question" to ask.