Book of Wise Investors

There exists a belief that diversification not only reduces risk but also returns. In fact, the world richest investors become rich not by spreading all the eggs into as many baskets as possible but by focusing on “a few” outstanding companies. However, we ordinary investors don’t have the nerves and guts to place more than 50% of our net worth in new and untested companies.

But one does have to note that, at least based on historical data, most low price-to-book ratios does yield higher returns over the long run than investment grades blue chips, as far as capital appreciation is concerned. In addition, smaller sized companies are still most likely need to retain a greater portion of their earnings to fund growth, hence unlikely to pay more dividends than blue chips.

My point is that it is more wise or economical to invest in a diversified portfolio of small sized and low price-to-book ratios companies through mutual funds and unit trusts to reap the highest returns from capital appreciation, and to invest in investment grade blue chips through direct stock ownerships for higher dividends and maybe smaller returns from capital appreciation. That is in the case of investing for the long run, long run as in at least 5 years or more.

Size of companies and volatility of them tend to go hand in hand. That is, the smallest sized companies usually have the highest volatility; I defined small size as below $290 millions in market capitalization.

Take note that the emphasis here is in investing in small cap or low price-to-book companies using a diversified portfolio, not dumping whole life savings in a single small cap company. The risk for investing in a single small cap or low price-to-book company is very high, it is not recommended for an average investor unless you are possessed by Warren Buffett.

The rationale for above advices stem from the high risk and high return concept from the capital asset pricing model combined with researches done by Eugene Fama and Kenneth French. They discovered that the smaller the market capitalization and the lower the price-to-book ratios, the higher the average returns. As a result, it would be wise to invest in a mutual fund consisting of the smallest market cap and lowest price-to-book ratios rather than hold them individually. These companies also tend to pay lesser dividends or even none, hence, no point holding them individually through direct stock ownerships. As for investment grade blue chips, it will be the exact opposite.

Do check the accuracy of Fama-French three-factor model for your chosen stock markets.

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