New investors are highly predictable with how and where they place their money. It is typical for them to invest in companies they’re familiar with or have heard of. What does that mean? New investors like to invest in massive well-known companies, and it isn’t as effective as they think.
The small minus big anomaly would argue that investors have a greater chance of success if they invest in a small-cap company. It’s a trading strategy that banks on the idea of potential growth rather than simply sticking with what’s already successful. Let’s explore how the underdog really can be the best option to root for.
The small minus big anomaly is the hypothesis that, over the long haul, small-cap companies tend to outperform large-cap companies.
The hypothesis stems from the ability of a small-cap company to grow exponentially, whereas when it comes to a large-cap company, it is limited in expansion opportunities. (Small-cap companies have a Market Cap of less than $2 billion.)
You might think, “Yeah, but I want to invest in companies I know have done well and are likely going to continue to do so.” The idea with the small minus big hypothesis is that if a small company grows exponentially, you’re more likely to have a greater return on your investment than with the steady profit of an already large-cap company.
The small minus big anomaly plays right into the momentum hypothesis with the belief that the good gets better. So, if a small company starts doing well, it has a greater opportunity to skyrocket and experience extreme growth.
In other words, if a small company experiences positive momentum, the probability of it experiencing rapid growth is much more likely, resulting in a greater return.
Picture the lemonade stand purchased by Barney. He has a growing business and does well. It is still a small business though. Barney isn’t the only lemonade stand out there. Delilah has a lemonade empire and is Barney’s biggest competitor.
There is also a local, named Cindy, in the town where both lemonade stands are open. Cindy wants to invest in one of the lemonade stands.
She could invest in Delilah’s because it’s much bigger and could make her more money, but the small minus big anomaly says that may not be the case.
The small minus big anomaly would say that Barney is doing well, so he will have the momentum to continue performing positively. With that projection, Barney will outperform Delilah as an investment, due to the opportunity to grow more.
Cindy knows about these trading strategies, so she decides to go with Barney’s business because of the momentum and positive performance return.
Once you start learning more trading strategies, they start to intertwine. Momentum has its place but specifically coincides with the small minus big anomaly. Your goal should be to become as aware of these strategies as possible to apply personal expertise.
The beauty of investing is there isn’t one way. Success comes with taking the time to learn what works and what does not. Keep up with Equities Lab’s content to ensure you learn some of the most relevant investing strategies.