Small cap stocks

Small cap stocks are publicly traded equity interests in smaller companies, typically companies with $1 – $5 billion in market capitalization and less.  Unlike most large cap stocks, which include household names such as IBM, Apple and Google, small cap stocks tend to be less well known to the public.  As an asset class, they tend to have more risk and be more volatile than large cap stocks.  This is mostly due to the fact that smaller firms have less access to capital and are less diversified in their operations than larger firms.

Historically small cap stocks have, generally speaking, outperformed their larger capitalization counterparts over the long run.  This is due to the fact that small firms oftentimes have a smaller market share, and therefore have more room for growth than larger firms, who may have already captured a large share of the market in which they operate.  As a result, smaller firms are oftentimes able to grow and expand their market share, revenues and earnings at a higher rate than larger firms.

Due to their relatively high volatility and risk, small cap stocks are best suited for investors with longer time horizons and higher risk tolerances.  For the right investor, small cap stocks can play an important and valuable role in his or her overall asset allocation.  By combining them with other asset classes such as domestic large cap stocks, international stocks and fixed income instruments, the portfolio can be tailored to the risk tolerance and time horizon of the investor.

Exchange traded funds

Exchange traded funds (“ETFs”) are securities which trade on an exchange and usually track a stock, bond, or commodity index.  Unlike an open end mutual fund, whose price is calculated daily at market close, exchange traded funds trade throughout the day and their price is determined by supply and demand.  Unlike a closed end mutual fund, whose market price frequently deviates from its net asset value due to supply and demand imbalances, ETFs are created and redeemed by certain market participants, resulting in additional liquidity and market prices which tend to more accurately reflect their net asset value.

Exchange traded funds tend to have lower expense ratios than mutual funds as they are usually passive and oftentimes track a stock index such as the S&P 500 (U.S. large cap equity), Russell 2000 (U.S. small cap equity), or EAFE (Europe, Asia, Far East equity).  They can also track a bond index such as the Barclays Aggregate Bond Index, or a commodity such as gold, silver or oil.  They thus provide a way for an investor to obtain exposure to an asset class in a low cost, passive manner.

Exchange traded funds are typically structured as corporations or investment trusts, and the investor is thus entitled to dividends and interest generated by the underlying assets of the funds.  Similarly, the investor is entitled to proceeds from the sale of the underlying assets upon liquidation of the fund.

Equity exchange traded funds are usually more tax efficient than open end mutual funds. This is due to the fact that ETF shares are created and redeemed in a manner which allows the share holder to have a cost basis in the fund which closely tracks the cost basis of the underlying assets of the fund.

Closed end funds

Closed end funds are, as discussed previously, mutual fund shares which trade on an exchange much like a stock.  Like open end funds, they are registered as investment companies under the Investment Company Act of 1940 and are highly regulated.  Unlike open end funds, which are priced at the end of the day and valued based upon the holdings in the fund, the market price of a closed end fund is determined by supply and demand for the fund on an exchange.

This results in a closed end fund having a market price which can at times vary significantly from its net asset value.  As discussed previously, this discrepancy can create an opportunity for an investor to buy fund shares at a discount to net asset value and sell fund shares at a premium to net asset value.

Closed end fund shares are issued once during an initial public offering, after which point shares can only be obtained by purchasing them from other shareholders.  This is on contrast to an open end fund, whose operators have the ability to create and redeem shares in reaction to capital flowing in and out of the fund.

Closed end funds tend to be capitalized in the $100 million to $1 billion range, which is much smaller than the typical open end fund, which oftentimes has a market capitalization exceeding $10 billion.  Closed end funds oftentimes employ leverage to boost returns, and frequently pay dividends and interest exceeding 6% per annum.



Preferred stock

Preferred stock is equity interest in a company which is has a higher claim to company equity and assets than common stock and a lower claim to company equity and assets than bonds.  Preferred shares typically pay higher dividends than common stock, and dividends must be paid to preferred stock shareholders prior to being paid to common stock shareholders.

Unlike common stock shares, preferred shares typically do not entitle their holder to voting rights.  Publicly traded preferred shares are issued by financial institutions such as banks and insurance companies, real estate investment trusts, and utilities.

Preferred stock can be either cumulative or non-cumulative.  If a dividend payment for cumulative preferred shares is missed, it will accumulate and be due in a future payment.  This is in contrast with non-cumulative preferred shares, for which no future dividend payment is due if one is missed.

As an asset class, preferred shares tend to be less volatile than common stock shares and more volatile than bonds.  While they tend to pay higher dividends than common stock shares, they offer less opportunity for capital appreciation.  While they typically pay more in dividends than bonds pay in interest, they have greater credit risk than bonds and therefore tend to be more volatile.

Asset allocation

As an investor, a primary goal is to manage the risk in the investment portfolio, and this is typically accomplished by allocating capital across different asset classes.  Which asset allocation is appropriate is dependent upon the time horizon, risk tolerance, and investment objectives of the investor as well as other external factors.

Strategic asset allocation versus tactical asset allocation

At the most basic level, asset allocation models are oftentimes classified as “strategic” or “tactical”.   A strategic asset allocation is based upon the time horizon, risk tolerance and investment objectives of the investor, while a tactical allocation takes into account market conditions, economic and political factors, security analysis, and other factors external to the situation and needs of the individual investor.

Strategic asset allocation

The strategic allocation will depend on factors unique to the investor.  For example, for a risk averse individual with a short time horizon the ideal strategic asset allocation will likely consist of a large amount of bonds and cash and a small amount of stocks, whereas for an aggressive investor with a long time horizon the ideal strategic asset allocation will likely consist of a large amount of stocks and a small amount of bonds.  When constructing a strategic allocation, a common rule of thumb is to base the bond allocation in the portfolio on the investor’s age.


For example, a 30 year old investor using this method would allocate 30% of the portfolio to bonds and cash and the remaining 70% to stocks, whereas a 65 year old investor would allocate 65% of the portfolio to bonds and cash and the remaining 35% to stocks.  Of course, this is only a rule of thumb should be used in conjunction with the time horizon and risk tolerance of the investor as well as other factors related to the financial situation of the investor.  We emphasize the importance of consulting with the appropriate advisers in implementing an asset allocation and a corresponding investment program.

Tactical asset allocation

Tactical asset allocation involves taking into account factors external to the needs and attributes of the investor.  Factors include economic, political, and market conditions.  For example, if the investor and/or investment manager believe that a recession is imminent, they may consider reducing exposure to equities and making a corresponding increase in the exposure to bonds and cash.  Another example involves factors related to the financial position of the individual company or companies in question, and the capital structure represented by the corresponding securities which are involved.  In this scenario, the investor may consider increasing exposure to those securities which are believed to be undervalued and decreasing exposure to those securities believed to be overvalued.


Large cap stocks

Large cap stocks represent publicly traded equity interest in the largest corporations in the economy, typically in the $10’s of billions and higher.  They tend to be well known companies and are usually household names.  Large cap stocks tend to be less volatile and risky than small cap stocks but typically offer less opportunity for growth and appreciation.

The shares of large cap companies tend to trade frequently and be more liquid than shares of small cap companies, which oftentimes do not trade as frequently and can be less liquid.

Large cap companies tend to be very established in their line(s) of business and highly diversified in their operations. Many large companies are known as “blue chip” companies due to their high level of quality.  The advantage which such companies have is that they tend to be less risky and more stable than smaller companies due to their breadth, size, and access to capital. The main disadvantage which these companies have is that they are unable to grow their revenues and earnings as rapidly as small companies.

As an investor, having a portfolio which is diversified across many different asset classes is a good strategy to manage the risk of your portfolio.  By combining large cap stocks with other asset classes such as small cap stocks, international stocks and bonds an investor can tailor their portfolio to their needs.


Risk tolerance and time horizon

An investment portfolio, and the underlying asset allocation which makes up the portfolio, is typically designed based upon attributes unique to the investor, such as risk tolerance and time horizon, as well as factors external to the investor.  Such external factors include market conditions, macro and micro economic factors, individual security analysis, as well as a large variety of other factors, the details of which will not be discussed here.  Here we will focus on two factors which are unique to each investor: the investor’s time horizon and the investor’s risk tolerance.  By varying the amounts of stocks, bonds and other asset classes based upon these two factors a portfolio can be designed and managed to meet an investor’s goals and objectives.

Time horizon

Investments with greater returns typically have greater risks, and investments with lower returns typically have lower risks.  An investor with a long time horizon can afford to suffer through market downturns; and for this reason could have a larger amount of risky, high return investments than an investor with a short time horizon.  An investor with a short time horizon should have a higher concentration of lower return, lower risk investments than an investor with a longer time horizon.

Risk tolerance

An investor with a high risk tolerance can afford to hold a larger concentration of high risk, high return investments than an investor with a low risk tolerance.  Such an investor will be less likely to become upset during a market decline and sell their investments.  This is a critical aspect of portfolio design and construction, particularly for individual investors.  An investor with a low risk tolerance would be more likely to become upset and sell risky investments during a market downturn, incurring a loss.  Such an investor should therefore hold a larger concentration of lower risk, lower return investments, as such investments will be less likely to decline in value by significant amounts.

Mutual funds

Mutual funds are diversified investment pools which are available to the general public, and are frequently used by investors to provide diversified exposure to securities as part of an overall asset allocation.  They are registered securities and are highly regulated.  They are frequently referred to as “investment companies”, and are structured in either an “open end ” or “closed end” format.  We will review the basics of open end funds and closed end funds here, and discuss some of their advantages and disadvantages as relates to issues such as liquidity and valuation.

Open end funds

Open end funds are mutual funds which can be redeemed or purchased by an investor on a daily basis, and can be done so at the market price, or “net asset value”, of the securities which are held by the fund.  The advantage of open end funds is that the investor does not run the risk of being unable to redeem his or her shares at the market price of the underlying securities in the fund.  The main disadvantage of open end funds relates to the fact that assets flow in and out of the fund on a daily basis, the net result of which can be a negative impact on fund performance.

Closed end funds

Closed end mutual funds trade on a securities exchange, similar to a stock.  The market price of the closed end fund will be determined by supply and demand of the fund on the exchange, and frequently will differ from the net asset value of the fund.  A shrewd and disciplined investor can purchase such shares at a discount from their net asset value, and sell them at a premium to their net asset value.  An advantage of closed end funds is that there are no daily inflows or outflows of fund assets, so the fund manager is able to manage the assets inside the funds in a long term manner.

Stocks and bonds

Stocks and bonds are some of the most common assets held in accounts by individuals, such as 401K and IRA accounts.  Previously we provided an overview of the asset allocation process and how it can be used to customize your investment portfolio based upon your investment objectives, time horizon and risk tolerance.  We also discussed briefly how this process can be implemented in your 401K account.  Here we will provide a very basic overview of stocks and bonds.


Stocks are publicly traded equity interests in businesses, and are typically riskier than bonds.  As an asset class, stocks are oftentimes broken down by company size (frequently referred to as “market cap” or “market capitalization”) and geographic region, (such as U.S., developed markets, emerging markets, and frontier markets).  Emerging market stocks typically can provide a higher return than developed market stocks, but are riskier.  As stocks are overall riskier than bonds, they are usually allocated more heavily to portfolios with a longer time horizon and for individuals with higher risk tolerances.


Bonds are debt instruments issued by businesses or governments (both national and local), and are typically less risky than stocks.  They are usually allocated more heavily to portfolios with shorter time horizons for individuals with lower risk tolerances.

Holding bonds entails several risks, including credit risk and interest rate risk.  Credit risk can be defined as the risk that the issuer will default and fail to make payments of interest and/or principal.  Interest rate risk is the risk that interest rates will rise, resulting in a decrease in the present value of the bond principal.  Interest rate risk can be somewhat mitigated by holding bonds until their maturity, however this is often difficult for an individual investor who is more likely to be invested in bond funds rather than individual bonds.


Stocks and bonds have different risk and return characteristics.  By combining them with other asset classes and weighting their allocation appropriately, an investor can customize an investment portfolio based upon his or her time horizon, investment objectives, and risk tolerance.

Choosing your 401K investments

Which investment options you choose in your 401K or 403B plan can have a significant impact on how your account will perform in the long run.  It is recommended that the assets in the 401K plan be allocated according to the time horizon and risk tolerance of the account owner, based upon an asset allocation model.  The asset allocation model has been shown to be one of the most critical determinants of long term investment portfolio performance.  Many 401K plans have limited investment options, although in most cases (but not always) they will have fund options available for each major asset class.  Sometimes there will be an option to invest in a self directed brokerage account, which allows the plan participant to purchase securities on the market, as opposed to choosing the from among the funds which are available in the plan.  We recommend following the steps below when determining the appropriate investment options.  We emphasize the importance of consulting the appropriate advisers in executing this process:

(1) Determine the appropriate asset allocation based upon your risk tolerance, time horizon and investment and financial goals

(2) examine the fund options in your 401K plan, and perform due diligence on the funds as necessary.

(3) allocate assets among funds as appropriate.  Investigate and allocate to self directed brokerage option within 401K if necessary