Making small-cap investing work (Part 2)

"Those who keep learning, will keep rising in life."

• Charlie Munger

Size does matter ?especially in investing.

Good things come in small packages, but this doesn't just apply to diamonds. In this case, small companies can be beautiful too, especially when you keep them for a long time.

While we are still licking our wounds from last week's Making small-cap investing work (Part I) where we learned that any dart-throwing monkey is a better investor than most of us are, it's important to understand what we can do to get ahead. To recap: it turns out that due to the random nature of the monkey's darts, their portfolios have a higher concentration of small-cap stocks vs the index, which is weighted towards large-cap stocks.

Lets think about this more literally: small companies are the nerdy ones with thick glasses in secondary school. They get bullied by the popular blue-chip waterpolo players, or aggressive-growth rugby players, but invariably they triumph over adversity and end up running the Facebooks of the world. It takes time before one becomes Mark Zuckerberg, and investors need to ride out the extra short-term volatility and periodic underperformance that might occur to achieve the long-term benefits of investing in small-cap stocks.

Nobel-prize winner Eugene Fama and his partner professor Ken French looked at the numbers and found the small firm effect prevalent everywhere.

All over the world, small companies have outperformed large companies by 2-3% per annum. That may not sound like much, but compound that over a long period and it will do wonders for your performance. A $10,000 investment in 1970 in the small firms of the developed world would have grown to over $1.7 million today, whereas the large firms would have grown to less than $580,000, 1/3 that amount.

Expose yourself to a diversified pool of small-cap stocks and keep them in a safe with your diamonds - try not to touch them for as long as possible and you may be handsomely rewarded.