A reader on Twitter recently sent me a note that said: "I don't understand why you are long these volatile small-caps and not safer stocks like AAPL or GOOGL."
My response to that observation is that I am confident in my ability to trade, and therefore I want to trade the stocks that have the potential to make the biggest moves so I can make the most money. The small-cap names that I tend to favor, have more risk and more volatility, but they also offer much more potential profit.
It is the classic tradeoff between risk and return. If you want higher returns, then you have to take on more risk or have a better way to manage risk. I believe that if I employ an effective trading methodology and stay disciplined, then I will do far better trading high volatility small-caps rather than holding onto a big-cap name.
Every day I look at a list of stocks that are moving more than 10% that day. Big names like Apple (AAPL) and Alphabet (GOOGL) seldom make daily moves of that size. There are usually at least 30 stocks that move over 10% in a day. The risk of trading them is high, but the rewards are great if you do it right.
Every trader needs to decide what trading vehicles they will use. Some focus just on indexes and watch every tick in the futures. There are some that prefer to trade highly liquid big-caps that are common household names. It is easy to buy and sell these stocks, and if you are personally familiar with them, the risk does not seem as great.
I Prefer Smaller Stocks and Secondary Names for Several Reasons
I believe that my fundamental and technical research can provide me with a better edge in a stock that isn't followed by 100 analysts and every large fund in the world. There is nothing I can find out about an AAPL or a GOOGL that big money doesn't already know. Perhaps I can apply some psychological insight or use the chart to manage a trade, but I don't have any substantial edge over others that are trading the stock.
Most people have no idea how to find a good unknown small-cap or how to research them. That gives me an edge right there. Warren Buffett has said if he didn't have such a huge amount of capital to trade that these smaller stocks are where he would operate.
With a small-cap name, there is often substantial manipulation and a large disconnect between valuation and the market price. My edge is that I can look for ways to profit when the gap closes.
Of course, trading requires much more work than buy-and-hold investing, but the big risk that is overlooked with buy-and-hold is that it is tremendously difficult to identify the stocks that are going to be the big winners over a very long period. Even Warren Buffett has said that only a handful of truly great stocks exist. Finding these great stocks is easy after the fact but hugely difficult prospectively.
People have the tendency to focus only on those names that have done well. They forget about all the stocks that were supposed to be the next Apple that is now out of business. Buy and hold investing carries a very high risk if your trade selection is poor. For example, if you bought IBM 10 years ago, you have lost about 60% of your money.
There's No One Correct Way to Approach the Stock Market
What works best is highly personal and will depend on risk tolerance, the amount of time you want to spend on research, and how closely you want to watch the market.
Every trader should have some funds in long-term investments just as a matter of diversification. I've held names like Abbott Labs (ABT) and Johnson & Johnson (JNJ) in DRIP accounts, where dividends are reinvested for 25 years. My best long-term investment has been Altria (MO) which has outperformed even AAPL due to its substantial dividend and several major spinoffs like Kraft Heniz (KHC) . If you are going to hold stocks long-term, it is a good idea to look at Dividend Reinvestment Programs.
If you want to be a successful trader, you need the right weapon. Small-cap stocks are my choice because I believe they offer me the best opportunity for large gains with less risk if I use good discipline.
There are always periods when your preferred weapon will be suboptimal, but that is just the cyclical nature of the market. Find the right weapon and then learn how to use it.