Financial journalists were just about the only winners in 2008. Whether it be Robert Peston on the BBC, the bookworms of The Economist, or the gorgeous anchor babes on CNBC, business reporters have had more front pages than Madonna.

Now they’re squeezing every drop from 2008 with their end-of-year roundups.

No time to read them all? Here’s what they’re saying in summary:

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What follows is a personal post, but I believe it’s relevant to investing. I won’t be discussing underpriced stocks or earning more money. Instead I’ll share something that for me puts the business of personal finance into perspective. Call it an end of year message.

I’m visiting my parents. In the next room, my gentle and intelligent father is asking my mother when he’ll have to leave the house again. It’s the third time he has asked in the past half hour. I can’t make out all the words, because he is slurring them.

He’s confused and agitated. Soon he’ll ask my mum - his wife - to take him to the bathroom. He goes every 45 minutes, sometimes messily. I wonder if they’d ever thought of such things when they met 40 years ago.

Dad wooed my mother one summer by the beach. He took his pasty, portly frame to the seaside every weekend, talked about surfing, and hid that he couldn’t swim. Mum was a church-goer who’d never had a drink. And now here they are, old and still together even as they fall apart.

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Image by: monstershaq

Bad news: When your sister, mother or lover said “You really shouldn’t have” when you gave them that expensive gift, they meant it. You should have shopped smarter and saved your money instead.

Academics at the Stanford Graduate School of Business recently discovered that:

• Most gift givers assume an expensive present is better appreciated
• Gift receivers don’t appreciate expensive presents much more

I’ve just negotiated another gift-giving holidays with my family. Years ago, when I was the first of my brothers and sisters to get a well-paid job, I spent far too much on presents. That might sound like I’m just being mean, but the problem wasn’t only that the presents weren’t - frankly - appreciated relative to how much I’d spent on them.

The big problem was I bought bad presents just because they had a bit of ‘bling’ - hiding my 20-something insecurities behind a price tag. More importantly, I can’t deny I involuntarily judged my siblings’ reactions. Didn’t they appreciate my gift cost four to five times what they’d spent on me? (Yes, I was an idiot!) Worst of all, my sister pointedly told me she felt my gifts made all her presents seem cheap.

What we all really cared about was whether it seemed like we’d been thought of and appreciated when the gift was chosen. While we all went in turn through the ‘expensive presents with a new job’ phase, we’ve now settled down to all giving small, very personal presents. (Not before time, as nephews and nieces have entered the gift-buying equation.)

It turns out my family’s experience mirrors what Stanford’s studies discovered:

1: Expensive engagement rings aren’t worth it

In their first study, the Stanford researchers looked at engagement rings - a one-off big ticket item where you might expect extra expenditure to pay dividends. But in practice the researchers found:

• Men consistently thought their rings were more appreciated by their fiancées the more expensive they were
• Fiancées did not rate themselves as any more appreciative if the rings were more costly

Of course! While there’s a lot of marketing pressure on young romantics to prove their love at the jewelry store, the fact you’re asking someone to marry you is about as big a statement you can make.

2: More expensive birthday gifts aren’t more appreciated

In the second study, the Stanford researchers asked participants to think about a recent birthday gift:

Participants described a variety of gifts, including T-shirts, CDs, jewelry, wine, books, and home décor items.

Again, those who were givers expected that more expensive gifts would make the recipients feel significantly higher levels of appreciation. In contrast, the recipients said they did not feel greater appreciation levels for gifts that had cost more.

Fact: It’s just not worth spending that extra chunk of cash. Researchers found givers would spend $100 on gifts that receivers would only pay $80 for. The excess $20  is a ‘deadweight loss’ in economic terms. Now you know why those Christmas chocolates are so absurdly overpriced.

If you see something the recipient would truly love that costs a little bit more and you can easily afford it, I’d say buy it. Otherwise, this study is a green-light to cut 20% off your gift budget.

3. An iPod isn’t any more appreciated than a CD

This one did surprise me:

In the third study, participants were asked to think about giving or receiving either a CD or an iPod as a graduation present. Once again, those who were randomly assigned to be ‘givers’ thought by giving the more expensive iPod their present would be appreciated more in contrast to the CD. The ‘receivers’ rated no difference in appreciation levels, regardless of which item they were told to think about getting.

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Small cap stocks can increase your portfolio returns, but they’re also more risky investments than large caps. In this post I’ll outline the six key advantages of investing in small caps versus bigger companies, and I’ll also point out some of the extra risks.

Advantage #1: Smaller companies are less well researched

An army of analysts, brokers, traders and journalists pours over every share listed on the major stock markets. Each individual is looking for an insight that others have missed such as:

• Increasing earnings (perhaps hidden by unusual expenditure)
• An overlooked new product
• The arrival or departure of a key executive
• Undervalued assets on the balance sheet (particularly property)
• Legal developments
• Too much cash being spent on the corporate washrooms
• One of a million other things

A useful nugget might be revealed in an interview in the trade press or be buried in the small print of the company’s final results. Anything material must be declared to the market, but a lot of investing comes down to judgement. If you understand the ramifications of a piece of information better or more quickly than others, you still have an edge over them.

The key point regarding small caps is these professional analysts overwhelmingly concentrate on larger companies.

Analysts have to pay their bills, too. And they’re much more likely to sell their research to fund managers looking to put millions into a major oil share. Brokers concentrate on bigger companies, too, since they need commission from institutions who deal in volume. And institutional traders aren’t likely to pursue micro-stocks worth less than the value of their own house.

These analysts all cover Apple (AAPL), the tech giant:

Actual, American Technology Research, Argus Research, Atlantic Equities, Bank of America Securities, Barclays Capital, Bernstein Research, BMO Capital Markets US, Citigroup Investment Research, Credit Suisse, Deutsche Bank Research, FTN Midwest Securities, Gabelli & Company, Goldman Sachs, JP Morgan, Kaufman Bros, Kintisheff Research, Morgan Keegan, Morgan Stanley, Needham, Oppenheimer & Co. Inc., Pacific Crest, Piper Jaffray, RBC Capital Markets, Standard & Poors, ThinkPanmure, Thomas Weisel Partners

These cover Psion (PON), the UK-listed technology small-cap:

ABN AMRO, Panmure Gordon, Seymour Pierce, Teathers Limited

With which share are you more likely to spot something others have overlooked?

Advantage #2: It’s easier to double the sales of a smaller company

• A small fast food chain can roll its format out to more cities or countries
• A small manufacturer can devise a breakthrough product that becomes a global smash, quadrupling its sales
• A one-magazine publisher can start a second magazine

It’s far harder to double the $10,000 million turnover of Starbucks (SBUX) than the $100 million turnover of London-listed Carluccio’s (CARL). Not impossible - giant companies become giants, after all. But by definition only a few big companies will become giants, whereas a lot of successful young companies can and do grow fast.

‘Elephants don’t gallop’ is how investment legend Jim Slater put it. He prefers sprightly small caps to elephants.

Advantage #3: Small caps often get re-rated

Quick reminder: The price-to-earnings (P/E) ratio is a measure of how highly rated a stock is. If the market believes earnings are going to rise a lot in years to come, it will pay more for shares in that company now, compared to a plodder going nowhere. In other words, the P/E ratio will be higher for the fast-grower.

Generally, small caps trade on lower P/E ratios than larger companies, at least until their ’story’ becomes widely appreciated. Not always: tech start-ups soared in the dotcom bubble on stratospheric P/E ratios, and big companies can fall out of favour and see their P/E drop. But usually smaller companies are on lower ratings, perhaps because they’re riskier.

In hunting for small cap growth shares, you want to find an exciting company that’s either new or that has a new story, but which hasn’t been fully noticed by other investors yet. (If everyone believes the company is going to keeping growing at 20% a year, the P/E ration will have already been bid up, and will be vulnerable to a de-rating if they disappoint.)

Jim Slater explains the power of P/E re-rating very well in The Zulu Principle.

You see something special in a small cap company when it is still relatively unknown. This company is lumped in with the other small caps in its sector, on a P/E of say 10. As it outperforms and more people are convinced its earnings growth is sustainable, its P/E ratio could increase to say 20.

This re-rating has a dramatic effect on your returns, compared to if the company simply grew its earnings but wasn’t re-rated:

Let’s suppose the re-rating occurs as earnings are growing at 25% a year and are forecast to keep doing so.

The combined effect of the change in earnings and the higher multiple increases your gain from 25% to 150%, like so:

(100 + 25) x (20/10) = 250
Original investment = 100
Gain = 150%

This dramatic return is what attracts private investors to fast-growing companies.

Be warned, finding consistent growth shares is not half as easy as it sounds. Over the long-term, value investing has a better track record. But the market continually offers up growth company opportunities to those few who can spot them.

Advantage #4: Your knowledge can give you an edge

You’re not going to be the first investor to notice McDonald’s burgers are better than they were. Millions eat at McDonalds (MCD) every day.

but you could be first to spot bigger queues at the Gourmet Burger Kitchens run by Clapham House (CPH).

Expert or local knowledge is more likely to be worth something when evaluating small caps. Your mum might say her new indigestion pills are amazing, but the Big Pharma company that makes the pills already produced research telling analysts that months ago. Your insight was right, but it’s too well-known to be valuable.

• Whether this sort of information can be really be ‘new’ in an efficient market is a hotly debated topic. I don’t think the market is always efficient.

• If you think the market is truly efficient, you should only invest in index trackers, rather than individual shares, whether small cap or large cap. You’ll probably do better than active investors, though we’ll have more fun! (I cover both styles of investing on Monevator, so please do subscribe).

• If you think the market is somewhat efficient, it’s clear smaller companies offer a lot more opportunity for private investors to spot the information the market has missed

Advantage #5: You can buy small caps, ‘they’ can’t (so be glad you’re not a billionaire)

Some funds are dedicated to small caps, but the majority invest in larger companies.

Imagine you manage a giant pension fund. It’s hardly worth you glancing at the share price of a small cap, because:

• You won’t be able to invest sufficient money into a small company without moving the share price.
• Investing across hundreds of companies, you’re not going to be able to keep track of the activities of small caps unless you’re the next Peter Lynch.
• If you do manage to invest a significant proportion of your millions under management into a small cap, you’ll probably have to declare it publicly. Everyone will then know what you’re buying, and bid up the price (fine if you’ve finished buying, but bad if you’re still building a position).
• Even if the share price doubles, a small investment will barely impact a massive fund’s returns.
• Your mandate might bar you from investing in small companies anyway.

Compare that to the portfolios of us private investors:

• We can invest a significant portion of our wealth into even a micro-cap without moving the price much.
• We can put our money into as few companies as we choose.
• We will notice a doubling or tripling of the share price in a ten stock portfolio. (Oh boy, will we notice!)

Advantage #6: Small cap indices have historically produced greater returns than large caps

The advantages we’ve looked at apply to picking individual small cap stocks over large caps. But a broad basket of small cap shares has historically done better than large caps, too, especially when you add value versus growth to the mix:

Exactly why this situation should persist is an old puzzle, but a New York Times article on the small cap advantage proposes an answer:

By definition, an overvalued stock has a larger market capitalization than would otherwise be the case. Its price-to-book ratio is also higher, and thus it is closer to the growth end of the growth-value spectrum. Portfolios of large growth stocks will contain a disproportionate number of overvalued issues, and should, on average, lag behind the market.

The opposite is the case for undervalued stocks. So small-cap value portfolios will have more than their share of them and should beat the market in the long term.

We’re not looking specifically at value versus growth here, which does juice the returns further. The take away for now is that if you invest in a basket of small caps, history suggests you’ll have a good following wind with you.

Remember: Small caps investing is more risky

Small caps offer advantages, but there’s good reasons why even private investors often favor bigger companies:

• Small caps are more volatile (at both the individual and index level)
• Small caps go bust (or near as damn it) much more often
• The spread between buying and selling prices can be large, so your new investment shows a sizeable immediate loss
• They’re much less liquid - if bad news hits the company, you may not be able to sell your holding quickly, or only at a very low price
• They’re arguably more prone to hype and investment mania
• Small caps are often more closely correlated with the domestic economy

So is it sensible to invest in small caps?

The evidence says investors should drip money into index trackers over the long-term. You’ll get the average market return that way, and you won’t pay all the fees associated with buying and selling individual shares, let alone over-trade and do worse.

One middle-way solution is to invest say 10% of your portfolio in a small cap fund, to get some benefit of the broader small cap gains we considered earlier without taking on too much volatility. Several small cap index trackers and ETFs track the North American market. UK investors aren’t so lucky, and are best off looking at cheap investment trusts with decent long-term records, such as Aberforth Smaller Companies and the Rights and Issues Trust. Avoid expensive small-cap funds with up-front charges!

But suppose you decide to invest some portion of your worldly wealth into individual stocks, rather sensibly buying the market via index trackers. Perhaps like me you enjoy the challenge. You find investigating companies interesting, and you’re prepared to risk doing worse than a passive investor for the possibility of doing gloriously better.

In that case, I believe investing in small caps versus large caps has advantages we just can’t afford to ignore in seeking an investing edge.

There are more than 6,500 actively traded US stocks. Some 2,000 companies are listed on the London Stock Exchange. 2,271 Japanese companies call the Tokyo Stock exchange home. Then there’s China, India, Canada, Germany, Australia…

Happily, you can forget about companies, earnings, forecasts and ratios and still make more money than most investors.

By passively investing in index tracking funds instead of managed funds or your own stock picks, you’ll capture the benefits of equity investing quickly, cheaply and relatively safely.

This post explains why index funds are the best choice for your core equity holdings. (What’s an index? Wikipedia: Stock Market Index).

Why index funds produce superior returns

Index investing is all about simplicity, so I’ll try to keep this brief.

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Important: What follows is not advice to buy or sell ANY shares. I’m a private investor, storing and sharing my notes. Read my disclaimer.

Just a quick update to my share write-up in November on London-listed The Clapham House Group. (Google Finance: LON: CPH).

The shares have moved from 53.5p to 93.5p, so my caution was not warranted. I wrote back then that I was not comfortable with the group’s loan arrangements:

According to section 19 of the accounts (which were compiled before the Bicycle Club sale, remember), Clapham House then had £19 million in bank loans, which will mature between 1 and 5 years from now.

This situation was addressed in Clapham’s December 10th Interim Results:

I am pleased to announce that we have as at 9 December 2008 renewed our main banking facilities until June 2012. As a result, we have incurred a one off arrangement fee and will be paying a small increase in margin. The same total Company facilities of £21.7 million remain in place following this renewal.

This was what I wanted to hear; the group’s Gourmet Burger Kitchens are throwing off cash, but if Clapham hadn’t been able to extend its banking facilities when the loans matured it could have faced a crippling cash call.

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Anyone who reads personal finance blogs is clearly more interested in money than the average person. If you write a personal finance blog, you’re even more interested in money (even if blogging won’t make you any).

Can you be too interested? Are we deluding ourselves into thinking we’re being economically literate, whereas really we’re just being tight?

Andy over on Saving to Invest recently asked himself if he’s a cheapskate:

I admit I am much more careful with my expenses and probably question purchases much more than I used to. Still, being called a cheapskate? That hurt. I like to think of myself as Frugal. I am well aware that hoarding money is unhealthy and have no issue spending money where needed. But unnecessary and impulse spending really frustrates me. For example why pay full price for a great purse, when most likely it will be on sale in a couple of weeks. Patience is a big money saver!

I’ve seen more people ponder this sort of thing as the financial markets have unraveled. Perhaps people wonder what they’ll do if they lose their jobs: you can’t save money when you’re not making any. Or maybe the fact that money is now top of the news agenda makes us finance bloggers feel like our passion has gone mainstream. Being frugal was cool when it was underground - like listening to Arcade Fire before they became mall music.

When your dad visits and he asks to borrow your records, it’s natural to think you should get into jazz. When your spendthrift cousin tells you he’s selling his car to use public transport because of the recession, you might wonder if it’s time to buy a discounted Porsche.

Expecting this recession for a long time, I’ve:

• Spent less than I earned
• Avoided buying a house, because I saw prices were in a bubble
• Saved and invested 30-50% of my income for years
• Tried to remember what’s more important than material things
• Been inspired by everything from family illness to immigrants in kick-starting my journey to financial freedom

But now that house prices are falling and we’ve been racked by crisis after financial crisis, I can’t help wondering what I was waiting for. Was being frugal actually a safety blanket of sorts?

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Any reader who hasn’t yet read The Intelligent Investor by Benjamin Graham is advised to put down this blog and pick up his classic book. It’s 50-years old, yet it has an uncanny knack of being relevant for each new generation.

Known as ‘The Dean of Wall Street’, Graham was Warren Buffett’s mentor and an intelligent buyer of unloved companies trading at less than book value. A child of the Depression, Graham’s label for these companies were ‘cigar butts’; he’d look for one with enough value left in it to get a last puff by realizing its assets.

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