Lemonaid stand in the small cap debate

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linate
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Lemonaid stand in the small cap debate

Post by linate »

To me it was always intuitive that small caps should do better, cause they can more quickly double etc their profits. A lemonaid stand can quickly double its profits, which something like Walmart can't do.

But I think the argument that counters mine is efficient market theory. The market knows the stand can double its profit so the market prices that into the price of the lemonaid stand stock. Even if profits double, the price of the stock does its own thing in anticipation and as time goes on.

So is my only way of being right that small cap is better, due to mistakes or inefficiencies in the market? If a doubling of profit isn't factored into the stock price, there definitely could be a small premium.

But is there more to it beyond inefficient markets? The bottomline is that the lemonaid stand can quickly double its profits, whereas Walmart cannot. I don't know how to articulate it, but I think there's more to it than inefficient markets.
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Re: Lemonaid stand in the small cap debate

Post by linate »

Maybe, it does boil down to market efficiency. If the market is inefficient, there could be a size premium if profits go up faster than expected. The risk is that the inefficiency is that profits lag expectations.
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Re: Lemonaid stand in the small cap debate

Post by whodidntante »

I could probably throw some rigor at it rather than this lazy swipe, but I think mega-cap companies achieve a level of size that dims their future prospects. There is basically a parade of the formerly largest companies that are not on top anymore.

On the other hand, there is some really tremendous crap down low. Listening to the investing geniuses you play golf with might lead you to buy something that trades like a lottery ticket. Which is to say it either hits or goes to zero. Mega caps sometimes do that, but what they do much more often is just suck for decades on end.

It's fairly easy to avoid investing too much in either type of company.
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Re: Lemonaid stand in the small cap debate

Post by nps »

You seem to be suggesting that investors should value a "doubling of profit" the same no matter the actual dollar amount of profit. That's not how it works.
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Re: Lemonaid stand in the small cap debate

Post by rkhusky »

I've heard it said that most of the stock market gains come from a small number of companies. Are you smarter than everyone else in separating those that hit home runs from those that strike out? Can some really simple number that everyone knows tell you which companies are going to do better than other companies?
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Re: Lemonaid stand in the small cap debate

Post by White Coat Investor »

linate wrote: Mon Jan 16, 2023 8:06 pm To me it was always intuitive that small caps should do better, cause they can more quickly double etc their profits. A lemonaid stand can quickly double its profits, which something like Walmart can't do.

But I think the argument that counters mine is efficient market theory. The market knows the stand can double its profit so the market prices that into the price of the lemonaid stand stock. Even if profits double, the price of the stock does its own thing in anticipation and as time goes on.

So is my only way of being right that small cap is better, due to mistakes or inefficiencies in the market? If a doubling of profit isn't factored into the stock price, there definitely could be a small premium.

But is there more to it beyond inefficient markets? The bottomline is that the lemonaid stand can quickly double its profits, whereas Walmart cannot. I don't know how to articulate it, but I think there's more to it than inefficient markets.
It's not clear if it is behavioral or a risk story. Probably some of both.

Small cap stock performance is not higher "because they can double their profits." It's higher because the lemonade stand is more likely to go out of business than Wal-mart and because fewer people know about/care about it than Wal-mart.
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Re: Lemonaid stand in the small cap debate

Post by toddthebod »

linate wrote: Mon Jan 16, 2023 8:06 pm To me it was always intuitive that small caps should do better, cause they can more quickly double etc their profits. A lemonaid stand can quickly double its profits, which something like Walmart can't do.

But I think the argument that counters mine is efficient market theory. The market knows the stand can double its profit so the market prices that into the price of the lemonaid stand stock. Even if profits double, the price of the stock does its own thing in anticipation and as time goes on.

So is my only way of being right that small cap is better, due to mistakes or inefficiencies in the market? If a doubling of profit isn't factored into the stock price, there definitely could be a small premium.

But is there more to it beyond inefficient markets? The bottomline is that the lemonaid stand can quickly double its profits, whereas Walmart cannot. I don't know how to articulate it, but I think there's more to it than inefficient markets.
If there are 50 lemonade stands, and one doubles in stock price while the other 49 go out of business, is that a better or worse investment than Walmart?
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Re: Lemonaid stand in the small cap debate

Post by Kenkat »

Which do you think is more risky and likely to go out of business - Walmart or a random startup Lemonade stand run by inexperienced management? Wouldn’t you expect more in the way of return on your investment to compensate for this risk? That is one of the arguments for small caps - higher risk taken should result in higher returns.
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Re: Lemonaid stand in the small cap debate

Post by burritoLover »

linate wrote: Mon Jan 16, 2023 8:06 pm To me it was always intuitive that small caps should do better, cause they can more quickly double etc their profits. A lemonaid stand can quickly double its profits, which something like Walmart can't do.

But I think the argument that counters mine is efficient market theory. The market knows the stand can double its profit so the market prices that into the price of the lemonaid stand stock. Even if profits double, the price of the stock does its own thing in anticipation and as time goes on.

So is my only way of being right that small cap is better, due to mistakes or inefficiencies in the market? If a doubling of profit isn't factored into the stock price, there definitely could be a small premium.

But is there more to it beyond inefficient markets? The bottomline is that the lemonaid stand can quickly double its profits, whereas Walmart cannot. I don't know how to articulate it, but I think there's more to it than inefficient markets.
You can't think of the market as if it is in a vacuum by itself. Investors already know that small cap stocks have a greater potential for outsized returns. They already have a tendency to bid up small cap growth "lottery" stocks making it one of the worst performing categories on a size and value/growth basis. It is already priced-in (and then some).
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Re: Lemonaid stand in the small cap debate

Post by Jack FFR1846 »

Your efficient market theory is correct. Just like a single stock, a sector is known by all. If the sector is known to be recovering or falling by all, the price will reflect this. Jack Bogle said in an interview, which I can't find right now that specifically, small cap value is a has been opportunity. Everyone "discovered it" 20 years ago and then bought it, ratcheting up the price to the point where it was undervalued based on price. His point was to stick with the haystack. I'll make up an example.

Acme is a 100 Billion dollar lemonade company and makes lemonade day in and day out, having sales that haven't changed by $10 per quarter in a century. Their stock costs $100 and goes up 7 cents every quarter day in and day out.

David's Lemonade is a small startup who is just getting into the market but just landed a sale with Kroger. Their stock before this sale was 1 cent but after the sale doubled to 10 cents, way beyond what it would be worth if Kroger is their only sale. The market assumes they're going to get Costco, Stop & Shop and Wal Mart.

So is the small guy, David the stock to buy? Well, we have some insider information. Acme just sent its sales people out with proposals to their selling stores. Feature Acme and remove all competitors for a month and they'll rebate the stores $100 for every $150 in lemonade sold. The stores, all selling on low margin have all jumped on this and wiped David's inventory off the shelf. David is talking to his lawyer about unfair trade but is limited on funds and Acme has more lawyers than David has customers. It looks like the news is about to hit the market. Regardless of possible future litigation success, David is in for a rough time. He's expecting stock to drop to 2 mili-cents.

So is buying David the smart move? You don't know about any of the above as it's not yet public. If you don't happen to be on the news wire when the story breaks, everyone's going to sell David's and you're going to be left with a near total loss.

If instead you own the haystack, the jump up in Acme and down in David's means zero to your total and you move along happily smiling as the market trudges up. If you don't have illegal insider knowledge, you know nothin'. That haystack looks mighty fine.
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Re: Lemonaid stand in the small cap debate

Post by TropikThunder »

toddthebod wrote: Tue Jan 17, 2023 8:41 am
linate wrote: Mon Jan 16, 2023 8:06 pm To me it was always intuitive that small caps should do better, cause they can more quickly double etc their profits. A lemonaid stand can quickly double its profits, which something like Walmart can't do.
If there are 50 lemonade stands, and one doubles in stock price while the other 49 go out of business, is that a better or worse investment than Walmart?
Sure it is, just pick which one is going to double and only invest in that one. What’s that Will Rogers quote?
The way to make money in the stock market is to buy a stock. Then, when it goes up, sell it. If it’s not going to go up, don’t buy it!
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Re: Lemonaid stand in the small cap debate

Post by NiceUnparticularMan »

As a general rule, if you believe in efficient markets and risk premia explanations, you have to figure out something bad, ie extra risky, about small stocks, value stocks, or so on, in order to explain higher expected returns.

Of course by the time a company is listed on a major exchange, it is already a pretty big company. But still, in addition to risks as dramatic as business failure, you can also think in terms of just disappointing results.

Like, if a listed company has a reasonable plan to double earnings over the next medium period and it is priced accordingly, but then earnings only go up 80% and not 100%, that might seem like an objectively good result, but it could still cause a loss for the stock's original investors (meaning those who bought based on the plan and not the results).

And so on. Point is once you assume markets are efficient at reflecting all available information in stock prices, it is the possibility of new information that contradicts in some way, possibly even just a relatively mild way, the old information that is dangerous for stock prices. And you might think of smaller companies as ones where there is greater risk of new information that materially contradicts the old information.
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Re: Lemonaid stand in the small cap debate

Post by nisiprius »

The question is how to regard "potential."

Smaller companies have the potential for far higher returns, but
  • Most of them won't achieve that potential, and
  • it's useless knowing that some of them will if you can't dependably tell which.
A $2 Powerball ticket has the potential to grow 500,000,000X. A $2 investment in a 4% APY bank CD does not. But that does not mean that the Powerball ticket is a superior investment. In fact we know quite accurately that the mathematical expected return on a Powerball ticket is -68%, i.e. Powerball pays out a total of $0.32 for every dollar spent on tickets, while the bank CD has an expected return of +4%.
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Re: Lemonaid stand in the small cap debate

Post by secondopinion »

linate wrote: Mon Jan 16, 2023 8:06 pm To me it was always intuitive that small caps should do better, cause they can more quickly double etc their profits. A lemonaid stand can quickly double its profits, which something like Walmart can't do.

But I think the argument that counters mine is efficient market theory. The market knows the stand can double its profit so the market prices that into the price of the lemonaid stand stock. Even if profits double, the price of the stock does its own thing in anticipation and as time goes on.

So is my only way of being right that small cap is better, due to mistakes or inefficiencies in the market? If a doubling of profit isn't factored into the stock price, there definitely could be a small premium.

But is there more to it beyond inefficient markets? The bottomline is that the lemonaid stand can quickly double its profits, whereas Walmart cannot. I don't know how to articulate it, but I think there's more to it than inefficient markets.
The company is of far higher risk of closing up shop. There is generally higher risk reflected on both sides of the biased coin (the bias being on the side of closing up shop); chances are such companies are priced in a manner that assumes the possibility of 100x+ growth and it is considered a nano-cap growth company. Essentially, there is a lot of positive skew in the returns. No inefficiency here.
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Re: Lemonaid stand in the small cap debate

Post by secondopinion »

nisiprius wrote: Tue Jan 17, 2023 12:00 pm The question is how to regard "potential."

Smaller companies have the potential for far higher returns, but
  • Most of them won't achieve that potential, and
  • it's useless knowing that some of them will if you can't dependably tell which.
A $2 Powerball ticket has the potential to grow 500,000,000X. A $2 investment in a 4% APY bank CD does not. But that does not mean that the Powerball ticket is a superior investment. In fact we know quite accurately that the mathematical expected return on a Powerball ticket is -68%, i.e. Powerball pays out a total of $0.32 for every dollar spent on tickets, while the bank CD has an expected return of +4%.
Right, the desire for positive skew is so high that people are willing to pay for it. I am not aware of many people who will engage in the speculation of the other way on one ticket (earning $2 with the risk of owing $1B for a $0.64 expected profit), however. Hence, that is why lotteries are designed to take everyone's money to pay some to the winner and not do this speculation uncovered.
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Re: Lemonaid stand in the small cap debate

Post by corpgator »

What is a lemonaid stand? Is this where injured lemons go to get patched up?
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Re: Lemonaid stand in the small cap debate

Post by Chuck »

corpgator wrote: Tue Jan 17, 2023 12:21 pm What is a lemonaid stand? Is this where injured lemons go to get patched up?
I waited longer than I expected for this response.
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Re: Lemonaid stand in the small cap debate

Post by Random Walker »

linate wrote: Mon Jan 16, 2023 8:06 pm To me it was always intuitive that small caps should do better, cause they can more quickly double etc their profits. A lemonaid stand can quickly double its profits, which something like Walmart can't do.

But I think the argument that counters mine is efficient market theory. The market knows the stand can double its profit so the market prices that into the price of the lemonaid stand stock. Even if profits double, the price of the stock does its own thing in anticipation and as time goes on.

So is my only way of being right that small cap is better, due to mistakes or inefficiencies in the market? If a doubling of profit isn't factored into the stock price, there definitely could be a small premium.

But is there more to it beyond inefficient markets? The bottomline is that the lemonaid stand can quickly double its profits, whereas Walmart cannot. I don't know how to articulate it, but I think there's more to it than inefficient markets.
I have at times thrown myself into mental contortions thinking about this sort of stuff. What always straightens me out is the simple thought that markets price risk. Riskier investments are priced lower and thus have higher expected return. Safer investments have higher valuations and thus lower expected returns. Small companies, like the lemonade stand, are more risky and thus have higher expected return.
Also, the expected return on a stock is the same as the company’s cost of capital. Riskier companies will have to pay more for a loan than less risky companies, and this translates into a higher expected return to the stock of the more risky company. To me it is intuitive that a mom and pop cleaners will have to pay more to borrow than would McDonald’s, and thus the potential return on mom and pop investment greater than McDomald’s.

Nowadays though, there is debate about the small cap premium. I think it persists if one screens for investment and profitability. In Larry Swedroe’s Factor Book, I think there is an appendix showing that when companies are broken up into deciles by size, there is a monotonic increase in return with decreasing size. I’ll go back and take a look at that appendix again.

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Re: Lemonaid stand in the small cap debate

Post by linate »

I think it's more than just whether the market is efficient. Small cap have higher potential for profit given how fast it can structurally increase profit. Value stocks have lower price to earnings, higher potential return. The only way to argue that the efficiency of the market cancels out higher returns, is to argue that small and value should fir some reason have similar returns than large caps... that the price of all sizes and pe will equal out regardless of profitability. I see no reason to assume that. If a stock is structurally made to be more profitable, it should have higher returns given more money can be made on it. Maybe the efficiency of the stock cancels out based on risk on volatility where more risk means more profit, but I don't see a reason why large small and value should all be the same returns. Maybe they're similar given market efficiency but more profitable stocks should have an edge.

Maybe small structures itself for higher potential returns, but I don't see a reason to assume small and large should inherently have the same ish return long term
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Re: Lemonaid stand in the small cap debate

Post by linate »

Warren Buffett got so rich because he focused on value stocks and profitability. His record is more than a fluke given how long he lasted and even if his record is hard to match. It's all about profitability. The way many people on here would argue, is that his stocks should have had his stock's profitability muted when efficient markets devalue that profitability.

I don't think indexes that utilize a similar approach to his, are inherently different. It all boils down to profitability. It's fair to think some of the best small and value stocks will on balance be profitable, and more profitable than large caps. That's the nature of business in general, and that's the nature of what makes large small and value all different
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Re: Lemonaid stand in the small cap debate

Post by alex_686 »

linate wrote: Mon Jan 16, 2023 8:06 pm To me it was always intuitive that small caps should do better, cause they can more quickly double etc their profits. A lemonaid stand can quickly double its profits, which something like Walmart can't do.
This is demonstrably false.

First, large companies have been able to leverage good ideas quickly and efficiently over large markets. i.e. if something is doing well in one country they can implement it over many.

Next, networking effects. i.e. the winner takes all.

And many other reasons.

The research showing this for the past 20 years is extraordinary. Note, this was not true 30 years ago prior to the invention of the networked desktop computer. Nor does it mean it will be true for the next 30.
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Re: Lemonaid stand in the small cap debate

Post by Apathizer »

whodidntante wrote: Mon Jan 16, 2023 8:20 pm I could probably throw some rigor at it rather than this lazy swipe, but I think mega-cap companies achieve a level of size that dims their future prospects. There is basically a parade of the formerly largest companies that are not on top anymore.

On the other hand, there is some really tremendous crap down low. Listening to the investing geniuses you play golf with might lead you to buy something that trades like a lottery ticket. Which is to say it either hits or goes to zero. Mega caps sometimes do that, but what they do much more often is just suck for decades on end.

It's fairly easy to avoid investing too much in either type of company.
Yes Felix and others have talked about this. While not just related to size, there's a fallacy many investors subscribe to that admired companies are inherently good investments which isn't the case. These are companies that are generally considered to be good to work for and benefit society, and they tend to be larger and more well known.

But as you say a large company eventually usually reaches a point that it's future prospects become fairly low. We might be seeing this now in the IT sector as companies like Microsoft are becoming less profitable and laying people off.

I think it's also informative to consider many companies now considered large value were once growth companies. This seems like to happen with companies like Microsoft. While it's current prospects are somewhat uncertain, it's products are still widely used and I think they probably will be in the future. It's just that the IT revolution has already happened.

At some point maybe Microsoft and the other technology companies might be similar to oil companies like Chevron now. Oil companies are generally considered value now since there's a push for decarbonization, but many and maybe most are still highly profitable. It seems something similar might happen with Microsoft.
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Re: Lemonaid stand in the small cap debate

Post by nisiprius »

secondopinion wrote: Tue Jan 17, 2023 12:08 pm...Right, the desire for positive skew is so high that people are willing to pay for it. I am not aware of many people who will engage in the speculation of the other way on one ticket (earning $2 with the risk of owing $1B for a $0.64 expected profit), however...
Actually I think there are many implicit examples of this, but obfuscated in a way that doesn't make them obvious.

Gambling systems, for examples, are versions of "martingales," and they all consists of a basic strategy of doubling up until you win. The theory is that eventually you must win, and the betting sequence is designed so that the eventual win pays back the accumulated losses and a bit more. One example of such a sequence is double-and-add-one: $1, $3, $7, $15, $31, $63, $127... When the win occurs, your net gain is equal to the number of plays. For example, if you win on the sixth play you net $63 - $31 - $15 - $7 - $3 - $1 = $6. Playing such a system you seem to have a steady, regular, consistent series of small wins. The problem, of course, comes if for any reason you are unable to keep playing until the win, in which case you have a catastrophic loss. The classic analysis is that you are stopped by running out of money or credit. In real life I think in many cases it is a failure of nerve when the bets become too big. With the gambler being tortured by missing out on a potential win occurring soon after they give up.

The characteristic of negative skew is a pattern of small steady wins punctuated by ruinous losses. If you are using what I call the "athletic" model of performance evaluation--simply counting times won versus times lost, and ignoring "by how much"--negative skew will rack up more wins than losses, and it's attractive for that reason.

Negative skew is also attractive because the situations that cause the catastrophic loss are so rare and so unusual that it is possible to "excuse" them as extraordinary circumstances that nobody could possibly have foreseen and surely cannot possibly recur.

Negative skew actually occurs a lot in investing. Long-term Capital Management followed a strategy now often characterized as "picking up nickels in front of a steamroller," and perhaps came close to bringing down the US financial system when it collapsed. One of the principals afterwards gave the idiotic excuse that it had been "a ten-sigma event," which mathematically means that it should only have happened once in 1,000,000,000,000,000,000,000 years. Or seconds. Or milliseconds. Whatever, more than the age of the universe. So it was just bad luck that nobody could possibly have foreseen, and certainly not their fault.

The once-famous Bill Miller and his Legg Mason Value Trust had the practice of buying more of his "high conviction" stocks whenever they fell. While his fund was beating the S&P 500 this was regarded as the exemplary behavior of a committed value investor. After it collapsed, losing back all of the gains over the S&P 500 in three years, it was described as "doubling down on his bad bets."

One of the explanations for the alleged small-cap value premium, beyond that justified by a standard-deviation measure of risk, is that most investors are willing to pay too much for positive skew and not willing to pay enough for negative skew. That is, it's asserted that small-cap value is a superior investment because it has negative skew.

In theory there's nothing wrong with having a personal taste for positive skew or negative skew. In reality, though, I think many investors don't know that this is what they are doing, and believe that the investments matching their personal taste are Just Plain Better than the market as a whole.

I would guess that very few buyers of Bill Miller's fund during the fifteen years during in which it beat the S&P 500 every year would have said "I am balancing the benefit of a high probability of a small outperformance every year against the risk of occasional years of catastrophe, and my judgement is that the benefits outweight the risk." I think most would have said "I think this fund is Just Plain Better, and that it is all benefit, no risk."
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Re: Lemonaid stand in the small cap debate

Post by the_wiki »

linate wrote: Mon Jan 16, 2023 8:06 pm To me it was always intuitive that small caps should do better, cause they can more quickly double etc their profits. A lemonaid stand can quickly double its profits, which something like Walmart can't do.

But I think the argument that counters mine is efficient market theory. The market knows the stand can double its profit so the market prices that into the price of the lemonaid stand stock. Even if profits double, the price of the stock does its own thing in anticipation and as time goes on.

So is my only way of being right that small cap is better, due to mistakes or inefficiencies in the market? If a doubling of profit isn't factored into the stock price, there definitely could be a small premium.

But is there more to it beyond inefficient markets? The bottomline is that the lemonaid stand can quickly double its profits, whereas Walmart cannot. I don't know how to articulate it, but I think there's more to it than inefficient markets.
The lemonade stand has more likelihood of being gone next week than it does of tripling your money. But the ones that make it can provide massive returns. But it is pretty much pure speculation at the smallest end of the spectrum.

Huge companies eventually find it difficult to grow. Maybe Netflix and Facebook are good examples because they reached sky-high evaluations on subscriber growth. But eventually you reach everyone with a phone or TV and then what?

Mid caps are a nice balance and a category that is often forgotten.
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Re: Lemonaid stand in the small cap debate

Post by rushrocker »

I have been thinking a lot about the persistence of the small cap value premium lately. Will it persist and why?

I'd love to get a factor tilter's opinion on the below:
  • There is no longer a barrier to entry to own these stocks: The premium that did exist might have only existed because it was too difficult to invest in these companies in the past. No one knew about the lemonade stand. Therefore, there might have been inefficiencies that could have been taken advantage of, or missed, by investors. Today, anyone from around the world can research and buy one of hundreds of small cap value ETFs in a matter of minutes. Thus, with more knowledge and liquidity, the pricing of the small value market is more accurate than ever before, and that's why we've seen the value premium produce a slightly negative return over the past 20 years, which I believe is the first time in history that a 20-year period has returned negative.
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Re: Lemonaid stand in the small cap debate

Post by MattB »

nps wrote: Mon Jan 16, 2023 8:23 pm You seem to be suggesting that investors should value a "doubling of profit" the same no matter the actual dollar amount of profit. That's not how it works.
The OP also seems to be ignoring the greater likelihood that a small cap stock will go to zero, as compared with a mega cap.
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Re: Lemonaid stand in the small cap debate

Post by MattB »

whodidntante wrote: Mon Jan 16, 2023 8:20 pm It's fairly easy to avoid investing too much in either type of company.
I'm now very comfortable with this answer. I buy the market, after several years of thinking I might beat it.
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