second largest market value stocks proves to generate significant excess returns in the U.S.
market.
The ideas about finding outperforming large-cap stocks not only contradict the size effect theory that small-cap stocks tend to yield higher risk-adjusted returns, but also against the Modern Portfolio Theory (MPT) which highly emphasizes the importance of diversification to reduce risks. I therefore firstly examine the arguments of size effect theory by comparing the performance between large caps (S&P 100) and small caps (Russell 2000) over the period of 31/Jan/1990-2017/5/30. I find the size effect may exist in many of the cases, but not as significant as it was before. This supports my initial ideas of picking single sock from the large marker value stock given it is too difficult to select it from the small caps, regardless the increasing uncertainties of performances. The literatures I collected also suggest the more concentrated portfolios usually accompany with expanding excess returns.
The investment strategy I propose in the Chapter 3 is a stock picking simulation among the No.1 and No.2 largest market value stocks, which has similar concept as Momentum Strategy that buying past winners and selling past losers . By comparing the two portfolios that are regularly rebalanced every 6 month, I find the 2nd largest market cap stock generated amazing excess returns while the No.1 stocks are poorly underperformed. In this paper, I provide explanations that No.1 stocks are more likely to experience Momentum Crash than No.2 stocks due to investor’s anchoring bias as they believe the No.1 stock might have been peaked. The ranking is an anchor against which investors judge the stock values.
Another explanation comes from the observation of fundamental changes. Many of the No.2 stocks are in the process of growing stage, that the fundamentals are yet to peak
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comparing with the No.1. Since the rankings tend to change accompanied with share prices ahead of the fundamental alteration, it is likely to earn profits by buying No.2 stocks, especially those upgraded from the lower ranks.
Although my research suggests buying the second largest market value stock for excess returns is workable, I believe this strategy shall be good to applied to other large caps except the No.1 stock as long as their rankings are upgrading. However, it would be difficult for individual investors to figure out the ranking changes in most of the time. Top three or four might be possible to identify but those ranked after the 5th stocks are unlikely to do so.
Therefore, my advisories for implementation would be picking those super large cap stocks with faster-than-peers’ market value expansion but staying away the top one.
The regular rebalances in my strategy are designed to be a mechanism in preventing the misbehaviors of investors. The stocks should be dropped if they fail to maintain their positions in the market value rankings, meaning they are too weak to be held in the portfolios, as what Momentum Strategy suggests. On the other hand, we should keep those with an upgrading position as they are apparently outperforming than peers. This is how momentum trading investors usually do. The difference would be my strategy has much longer holding periods and less trading costs given the market value ranking of the large caps does not change as often as the moving average of share prices.
Still, my results do not prove the strategy can work in other markets, or how No.3 and No.4 stocks perform in the similar simulation. It also might be the case that other, yet unidentified factors would be able to explain the results. However, my conclusion is that the circumstantial evidences in the literatures and in my study points toward the fact that large market value stocks are capable of earing better excess returns. Investor should find their own strategies that are best appropriate for them.
Further research could involve using a broader scope of markets and stocks to test whether the No.2 or No.3 stock outperform in many of the cases. For individual investors
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who are looking for single stock selections, the tactical use of this strategy can offer some performances.
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