Today's lesson: Expected value trumps volatility.
Anybody who's seen Swingers can tell you the average blackjack player knows to "always double down on 11." Why not simply hit? Because, in the long run, doubling down on 11 will win more money.
That's despite this other fact: If you hit the hand instead, you will win more hands than if you had doubled down.
Let me explain. According to blackjack legend Stanford Wong's Professional Blackjack, the expected value of doubling down on 11 when a dealer is showing a 10 is greater than hitting (approximately 17.7% vs. 11.7% in a 6-deck game).
However, the probability of winning the hand is lower than if you simply hit, because you don't get a second chance to make your hand if you get a small card on the double down. Doubling down is also accompanied by a much wider range of short-term results.
What's important is that the investor with long-term perspective will always double down, as in the long run he will win more. This is why successful investors focus on long-term value, while ignoring volatility.
Smaller-cap stocks, such as Overstock (NASDAQ:OSTK), Netflix (NASDAQ:NFLX), and Cree (NASDAQ:CREE), have shown excessive volatility relative to the overall market. This is at least partly due to lower trading volumes and the fact that smaller issues can affect the value of a smaller company drastically.
To illustrate, First Horizon Pharmaceuticals (NASDAQ:FHRX), a microcap which jumped 40% last Friday, had also fallen victim to a 81% single-day drop last summer on a $5 million revenue miss.
You won't see Wal-Mart (NYSE:WMT) shares drop 81% on a $5 million sales miss.
Yet, one of the main reasons investors fish the small caps is that smaller companies feature higher growth rates than larger, multinational firms like General Electric (NYSE:GE), Coke (NYSE:KO), or Microsoft (NASDAQ:MSFT). It's the law of large numbers.
In the long run, small caps tend to have higher expected returns than large caps, even while exhibiting greater short-run volatility. So, if you hold a highly volatile stock, ignore the swings. If you paid the right price to begin with, it won't matter how much the stock swings day-to-day.
If you like the idea of buying and holding smaller stocks, you're a lot like Tom Gardner and would probably love his Motley Fool Hidden Gems .
Jeff Hwang owns shares of Overstock and Cree. He can be reached at [email protected].
