small cap stock beta

Tonight, as I was giving the 'night time' bottle to our 15-month old, I finally figured out something I've been pondering off and on for a while. I wondered, why would a disciple of Modern Portfolio Theory (MPT) expect small cap stocks to provide out-sized returns solely because they are more risky? Actually, I really wondered why they would perceive small caps as more risky?

Having been exposed to arbitrage pricing methods enough to be dangerous, I thought perhaps a collection of small cap stocks should be equivalent to one large cap stock. Or vice versa, one large company is perhaps equivalent to a collection of small companies. But then I remembered the math related to beta calculations and how say 10 small cap stocks, each with betas around 2.0, if put together would create a portfolio that still has a beta of 2.0. The reason is because the beta statistic itself already accounts for the cancelling out of individual stock idiosyncrasies, thereby providing a measure of a stock's underlying covariance with the overall market, net of any 'noise'.

So then I thought, of course that's why MPT followers would expect small caps to provide out-performance (because of greater risk as measured by beta). But I wondered, what is it about being small that makes small companies qualitatively more volatile? It can't be they are too small to have diversified revenue streams, otherwise as implied above, this volatility would go away when many small caps are held together in one portfolio. Rather, it must be something to do with each individual revenue stream (i.e. business) itself being volatile/risky.

But then, why would small companies be predisposed to having volatile revenues? I thinks it's simply by default. In other words, if a company finds a stable revenue stream, they tend not to stay small for very long. Because once you find a stable revenue stream, you no longer have to be quite so nimble to survive, and you can begin to pursue efficiency at the expense of flexibility. You start hiring some MBAs to standardize processes, acquire competitors to transfer best practices, badda bing badda bang, you get BIG.

new year

Not that I was ever a prolific writer, but now that my one year of blogging has been accomplished (last year's resolution), there will be fewer, more sporadic posts going forward. Perhaps a wrap up, bare bones summary of my investing philosophy as it stands at this point in my life, but otherwise probably just random stuff I think my friends may find useful. Too bad my other resolutions weren't achieved (ahem,exercise,cough).

By the way, as previously mentioned was my intention, I've moved my real brokerage accounts over to folioinvesting.com and will henceforth occasionally share those actual results (e.g. the chart above). So far so good. Once I submitted the account transfer requests online, my retirement funds were moved from my employer (a large bank) over to folio in less than a week. Then, in about 60 seconds, I submitted orders for each of my IRA, Roth IRA, and Taxable Accounts to purchase the 100 stocks in my model portfolio and it was done the next day with $0 commissions (but you have to pay a $290 annual fee to get all you can trade for free). Next step may be to get the wifey to transfer hers and then see how well the platform really works for someone who wants to easily mimic someone else's model portfolio.

new addition to the blog roll

For us Gen X-ers who are somewhat interested in keeping tabs on those Millennials, you could do worse than read this guy. Check it out - http://leighdrogen.com/