Investors, Turn Down the Volume

In rock ’n’ roll, turning up the volume is not only welcome, but is often outright called for. While headbangers may want the volume cranked up, investors may prefer to have the volume set on low instead.

High volume signifies a large amount of interest among investors. Interest often is inversely related to mispricing. Put another way, the more investors there are trading a stock, the more likely the price fully reflects the current market sentiment about the company’s presumed prospects. Take a look at the table to the right. The average amount of money traded daily in the median S&P 500 stock is far higher than not only the median S&P SmallCap 600 stock, but also 90% of all other exchange-listed stocks. Care to guess which stocks are more likely to be mispriced: the S&P 500 stocks or the more than 4,200 exchange-listed stocks not in the index?

(A quick side note: The table to the right uses daily average dollar volume. It measures the number of dollars exchanging hands. Share volume, conversely, tells you how many shares are exchanging hands. Dollar volume is a better comparative measure across stocks because the lower-priced stocks can have higher share volume than higher-priced stocks simply because an investor can buy a greater number of shares for the same amount of money.)

If high volume is the problem, then low volume would seem to offer advantages. Less interest implies fewer eyeballs and therefore a greater opportunity for mispricing. This is in fact the case. Part of the reason value—especially small-cap value—stocks outperform over the long term is that there is less buzz about them. They’re not discussed on CNBC, featured in Money or otherwise talked about much by the various financial media outlets. As such, these stocks are more likely to be discounted and therefore have more potential upside.

Low volume is not without risks. If volume is too low, you may not be able to easily buy or sell without affecting the stock’s price. During periods of high buying or selling pressure, you may also have a hard time transacting. Think of it as a crowd rushing toward a doorway. Those first to the door will have little problem getting through. Those who aren’t first to the door can find themselves waiting while prices move against them, particularly if the doorway becomes jammed with others trying to get through.

There is a range where volume is low, but not too low to invest in. Where the breakpoint exists depends on how much money is being invested. The breakpoint is much higher for institutional investors (mutual funds, pensions, endowments, etc.) than it is for us individual investors. This is due to the economies of scale and capacity restraints that the money managers employed by institutional investors have to cope with. Money managers require a certain level of assets under management to remain profitable. At the same time, the larger the dollar amount of assets being managed, the more limited the universe of investable stocks becomes. This combination makes micro-cap stocks and even small-company stocks off limits to them and their institutional investor clients. There is simply too much money to invest to even consider these lower-volume stocks.

Individual investors are far less constrained. We can go much further down the volume chain because we have far less money to invest, relatively speaking. This is a huge advantage because it allows us to invest in stocks overlooked by institutional investors and thereby more likely to be mispriced.

How low can you can go? In trying to determine where to draw the line for the new stock strategy I’ve been developing (which you’ll hear much more about next month), we settled on requiring stocks to average at least $1 million in daily average dollar volume. This is one of the volume requirements we use for our Stock Superstars Report. As you can see from the table above, this number encompasses more than 70% of all exchange-traded stocks. It is a far lower breakpoint than most institutional investors can use, but still high enough to reduce the price impact from many subscribers responding simultaneously to an addition or deletion alert.

Those of you selecting stocks by yourselves can go even lower down the volume chain. AAII founder and chairman James Cloonan has suggested individual investors can go as low as requiring just average daily dollar volume of at least 10 times their desired position size. If you want to allocate, say, $5,000 to a stock, you should require potential candidates to average at least $50,000 per day in trading volume. The 10 times rule is a guide; adjust it if doing so gives you more comfort.