Break Out of the Box!

From time to time, I reissue pieces written and published in the past.

While I draw inspiration for subjects from current trends, I strive to offer insights having a longer shelf life than a week, a month or a year. This is one such piece that falls into the category of behavioral finance.

As an investor, I am always looking out for pitfalls others make, one, to avoid or, two, to exploit. One such pitfall which has not received the attention it deserves is the slavish devotion to style purity.

In the case of small-cap investing, style guidelines — in particular, selling a stock from a fund or portfolio because its market capitalization now exceeds some arbitrary threshold — can be, well, ludicrous. If you have found a winner, a stock which has increased several fold in price and has the potential to keep climbing, Why sell? As an analogy, this behavior is akin to winning a lottery jackpot and using the proceeds to buy more lottery tickets. Just because you were fortunate once does not mean you will always be so blessed.

The idea ties into a another notion which also does not receive the attention it merits. Technological advances typically require two to three generations before most of the economic value from the innovation has been extracted. As an example, consider the transistor. The modern transistor owes its heritage to work performed by Bell Labs in the 1940s and 50s and then by Texas Instruments. But the real innovation was the bulk production of cheap, reliable arrays of transistors etched on silicon chips beginning in the 1980s. This feat enabled the information revolution still unfolding in our midst. The important an innovation takes decades not years to for society to realize its full potential.

For the average person a key worry should be the obsolescence of their skill sets. Most acquire a set of skills or competencies in their teens and twenties which they rely on to see them through their working lives. The problem is the world changes. Skills sought yesterday may diminish in value tomorrow.

A way of hedging against this risk is to acquire a portfolio of companies exploiting new technologies or emergent demographic trends. Investing in a large number of such firms does not guarantee a winner, but it improves the odds. Over several decades, the gains from one or two such picks, that find a wave and ride it, cover the cost of other mistakes, potentially leaving a tidy nest egg.

Alas, this is not how most people invest. And, it is certainly not how most mutual funds are managed.

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