What should an individual investor fear most? A list of major fears might include the unexpected onset of a dreaded bear market for stocks, or perhaps high rates of inflation, something investor Warren Buffett has compared to a "gigantic corporate tapeworm." Judging from the talking heads on the financial TV show circuit, some investors apparently live in constant fear of what the folks at the Federal Reserve are thinking and what actions they may take to affect short-term interest rates. For investors, there seems to be no shortage of things to be afraid of.
But if you are taking a business-minded approach to investing -- and you should be -- then there is really only one thing to fear. No, it's not "fear itself," as FDR said. Rather, individual investors should fear mistakes. After all, mistakes are something that every investor can control. Bulls, bears, tapeworms, and Greenspans come and go, and there is very little that an investor can do about it. So, a prudent investing mindset is to recognize that some things in the financial world are uncontrollable and accept them for what they are. Instead, fear what is controllable -- fear yourself.
This does not mean that investors need to be mentally unstable, just self-aware and determined to avoid mistakes. One of the most effective means of controlling investment-related mistakes is with thorough stock analysis. While there is no way to fully incorporate such a qualitative element into a quantitative screening system, a filter such as the Foolish 8's $1 million to $25 million daily dollar volume requirement is generally conducive to sound, objective analysis. How? While it may not seem immediately obvious at first glance, a low daily dollar volume requirement actually helps limit potential investing mistakes by underscoring the need for thorough qualitative analysis.
The Foolish 8's low daily dollar volume requirement introduces the concept of investing in illiquid stocks, as opposed to more liquid stocks. In the stock market, liquidity and illiquidity deal with the dual ideas of availability and tradability of a particular company's shares, and how those two factors factor into day-to-day price movements.
Highly liquid stocks can have daily dollar volumes into the tens of billions of dollars. Thus, relatively large blocks of liquid shares can be bought and sold on the market during trading days without causing drastic price swings -- an important consideration for large investors such as mutual funds, whether they are taking a position in one stock or bailing out of another.
As has been discussed previously, mutual funds typically do not hold stakes in small companies, which are the firms most likely to have illiquid stocks. Some of this is due to simple math -- for a fund with $10 billion in assets, taking a 5% or even 25% stake in a company with a market capitalization of only $200 million or so is not going to make much of an impact. But even if a fund manager were to contemplate taking a big position in a small company, liquidity concerns would likely stand in the way.
As the October crash of 1987 and other stock market panics have shown, liquidity has a way of drying up when it is needed the most. In such extreme circumstances, even a fund owning only a small position in a relatively illiquid stock with normal daily dollar volume less than $25 million may be hard-pressed to find buyers for its stake. It could take a long time for a fund to get rid of an illiquid stock if something went wrong without trashing the share price altogether, potentially putting the manager's short-term performance record (and not to mention his job) in jeopardy.
It's unlikely that the average individual investor, with stock positions in the hundreds or thousands of dollars compared to the million-dollar-sized positions of the typical mutual fund, will ever face such a dire cashing out dilemma when investing in illiquid stocks. Still, problems can and do arise. For small investors and large investors alike, it is not quite so easy to "trade out of mistakes" in illiquid stocks as compared to more liquid stocks. If things get really bad for an already illiquid stock, the share price can buckle in no time and buyers can become scarce. More liquid stocks tend to offer a greater cushion when things go wrong, at least as far as potential buyers are concerned.
Some investors regard the illiquidity issue as the major "fear factor" that goes along with investing in small companies. However, as was stated earlier, the greatest fear factor that every investor faces is the possibility of making a mistake. As alluded to above, the ramifications of a mistake can be large when investing in illiquid stocks. As a result, the small company investor needs to be cautious and avoid potential mistakes through careful fundamental analysis, a disciplined focus on the most likely investment outcomes, and concrete decision-making.
In sum, the care needed to invest successfully in illiquid stocks is beneficial in that it promotes sound analysis, and perhaps even a long-term outlook on the part of the investor. In this way, the Foolish 8 requirement that stocks only have between $1 million to $25 million in daily dollar volume works not only as an effective screening device for identifying overlooked and under-followed small companies but also as a way to promote a few central investing principles.
Because of illiquidity, the small company investor must have the strength of his or her own convictions before and after making an investment. Given an appropriate amount of conviction, the great fear of making a mistake can be minimized right along with the misplaced fear of illiquidity. As I heard one veteran investor put it recently, small company investors should fear failure, not illiquidity.
[Motley Fool Research's Industry Focus 2001 features more on Foolish 8 small-cap stocks.]
