Filed under: Define investing, Money and Finance Today, Personal finance

This is the part of a new series of columns called “The Naked Truth,” by retirement expert Dan Solin. Please bring him your questions, in the comments box, and he will answer as many as he can.

Question: Can I find inefficiencies in the pricing of small and microcap stocks?

Answer: A common misconception is that small cap and small value stocks provide fertile territory for “making a killing” by finding mispriced stocks. However, the data tells a different story.

One study of the performance of 157 small cap value funds over a five -year period found that almost 90% of them under performed a small cap value index.

Another study of 53 small value mutual funds over a 15-year period found that 89% of them under performed a small cap value index.

If the highly paid managers of these funds, with all the resources available to them, can’t out perform the index, what are the chances that individual investors will be able to do so?

A more intriguing question is: Why are you doing this?

The volatility of a small value stock (as measured by standard deviation) is about 75%. But its expected return is roughly the same as the index, which has a risk of only 30%. Why would you take significantly more than twice the risk to accomplish the same expected return? You would be much better off just buying the index.

I comprehend the lure: You might hit it big with a big return. If this is what motivates you, go ahead and take a shot, but realize that you’re speculating, with an expected return of zero, minus costs.

Dan Solin is the author of The Smartest Investment Book You’ll Ever Read (Perigee Books 2006) and The Smartest 401(k) Book You’ll Ever Read (Perigee Books, June 24, 2008). Visit his website at Smartestinvestmentbook.com.

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