The phrase “It’s all relative” can easily be used in a discussion about investing.

Most studies of return anomalies are based on relative measurements. Value stocks are measured against growth stocks. Low-volatility stocks are measured against high-volatility stocks. Small-company stocks are measured against large-company stocks. If this sounds somewhat familiar, it’s because I discussed it last month in my article, “Momentum’s Role as a Driver of Stock Prices.” This month’s issue contains more discussion on relative investing.

On the company size front, adding micro-cap stocks can reduce volatility relative to a more traditional allocation of just large- and small-cap stocks. The line separating small- and micro-cap stocks is also relative. It shifts depending on market conditions. Michael Corbett, who manages Perritt MicroCap Opportunities (PRCGX) and Perritt Ultra MicroCap (PREOX) funds, observes here that the market capitalization ceiling for what defines a micro-cap stock has been as low as $150 million to $200 million and as high as $600 million to $700 million. Since micro-cap stocks are defined as the smallest exchange-listed companies, the market-cap range defining them moves depending on whether the overall stock market is up or down. In other words, it’s relative to the value of larger companies.

(As a quick aside, those of you who have been members for a very long time might find the name “Perritt” to be a bit familiar. Perritt Capital Management was started by former AAII Journal editor Gerald Perritt. Gerald oversaw this magazine from 1981 through 1983. Maria Crawford Scott replaced him as editor at the start of 1984, and I became editor after Maria retired at the end of 2009. The investment industry can, at times, have very few degrees of separation.)

The term relative can also apply to assessing valuation. We use relative valuations in our stock portfolios. For example, stocks are considered for replacement in the AAII Dividend Investing portfolio when their current yield is below their five-year average low yield.

Yields and valuations are inversely related. When a stock’s yield falls below the average low that investors have previously been willing to pay for a stock, it is considered to be expensive. The rationale is that if potential investors have previously not been enticed by the lower yield, they are not likely to be enticed in the future either.

The concept of relative valuations has been and is used by various investors besides us. Geraldine Weiss, for instance, used and advocated for relative dividend yield. Weiss considered how yields on blue-chip stocks ranged over a period of time. When a stock’s yield fell near the low-end of its historical range (indicating a relatively high valuation), she would sell the stock. When the yield rose to near the high end of its historical range (indicating a low valuation), she would buy the stock. Computerized Investing editor Jaclyn McClellan explains Weiss’ approach in greater detail here.

Before finishing, I want to address the subject of crowdfunding. A few days before we sent this month’s issue to the printer, new rules went into effect allowing all investors to buy shares of start-up companies. Previously, investing in start-ups was limited to accredited (high net worth) investors and institutional investors. Now, just about anybody can play the role of venture capitalist within the boundaries of the new rules.

Just because you can, however, doesn’t mean you should. I strongly advise limiting your crowdfunding activities to only money you have earmarked for gambling because it is probable (not merely highly likely, but probable) that you will lose everything spent on crowdfunded investments. I also strongly recommend reading “Crowdfund Investing: An Exciting New Alternative for Individual Investors” in the April 2014 AAII Journal. It was written by a venture capitalist and gives a thorough explanation of how to go about analyzing these types of offerings.

Wishing you prosperity, 

Charles Rotblut, CFA
Editor, AAII Journal
@CharlesRAAII