Will Investors Sell in May?
Another up day in the market - this is getting a little ridiculous. The Russell 2000 small-cap index gapped up yesterday and closed higher for the fifth consecutive day. The move to 720 has been nearly a straight line, and that makes me nervous. I've stated a number of times that I see the Russell getting to the mid 700's this summer, but I'd rather see it get there gradually than shoot straight there. That scenario increases the risk that there will be a more significant pull-back.
Take a look at the two year chart of the Russell below. By any measure, the rally from February has been awesome, forgetting about the massive move that came from the March 2008 lows.
But investors want to believe in this recovery, and the market is being propelled higher by ever improving economic data. Today we learned that China grew by nearly 12% in the last quarter, reporting the highest growth in the last three years. What's more, Singapore expanded over 30% in the last quarter.
According to Investors Intelligence the bulls are out in full force and bears are becoming more and more of a rarity on The Street. All of this is coming just weeks before the beginning of May, a time when investors have historically felt they should sell stocks and wait until the fall to buy them back. This year it's hard to tell what will happen, the bulls could take things higher. But if everybody thinks stocks are the way to go now, that's a pretty good indicator that they are not.
***So let's take a minute to discuss risk, an especially important factor for the small-cap investor to consider - especially given the rapid rise in many small-cap stock prices lately. Risk comes in several forms, and you should be aware of which to be on the lookout for.
What I've just been discussing is best described as market risk. The best-known risk of all is market risk. There is a general assumption, especially among new or inexperienced investors, that their purchase price of a stock is the starting point. It is important to remember the basic reality of market risk: Prices can rise or fall. Both directions can be triggered by developments either within the particular stock or the broader market. Even if a company has good things to report a weakening market can take its toll and drive a stock price down.
Whenever you invest in a stock, it's important to evaluate the pros and cons based on company specific fundamentals. But it is also important to evaluate your market risk. Can the stock's value fall? (Yes, it always can.) How far? (Theoretically to zero) How much can I afford to lose? Should I set a goal for myself to cut losses if and when it does fall? The best way to manage risk is to set a bail-out position for yourself in case market risk does go against you.
There is also liquidity risk. Liquidity risk means you don't have enough capital free to take advantage of emerging opportunities. For example, whenever you are fully invested you simply cannot take advantage of any new opportunities unless you sell an existing position. There is nothing wrong with being fully invested, but this can create a liquidity challenge if you're unable to sell your existing positions at attractive prices to raise capital for new investments. If you want to get into a new position, you'll first need to decide what you want to get out of, and if the opportunity represented by your new capital allocation is better.
Then there is diversification risk. Two versions of diversification risk have to be kept in mind. The first and most obvious is the problems that arise when you do not diversify enough. The second problem is over-diversification, a situation where an investor has too many positions and the performance of any one stock has little contribution to the overall gains of the entire portfolio. Your level of diversification is clearly limited by your available capital - it's a lot harder to be truly diversified with less than a few thousand dollars.
I'll talk a lot more about diversification in the future - there is a ton to say on the topic. Especially for the small cap investor who may want some diversification, but not too much since doing so limits the potential for higher returns. Picking just the right level of diversification is not easy, but it is a skill every investor should try to develop.
I'm always interested to hear what strategies small-cap investors employ in their portfolios when trying to balance capital restrictions with the desire for big gains by putting all available funds in a few select stocks.
Drop me a line and let me know how you balance these factors. My address is: editorial@smallcapinvestor.com
