The Kentucky Derby is, without a doubt, the most exciting horse racing event of the year. Millions of people who don't even watch horse racing pay attention to it, and it's featured all over the news. With all the coverage and excitement surrounding the race, it may be tempting to place a bet on it. Heck, even Jessica Simpson won a few dollars betting on it a few years ago on an episode of her show The Newlyweds (Sadly, I lost a pretty penny betting that their marriage would last more than five years).

But here's the best advice I can give you regarding the Derby: Don't bet on it. As the most-watched race of the year, you won't have any edge -- there's too many other experts watching it. In his book Picking Winners, horse-betting expert Andy Beyer advises readers to "Only go to tracks where there aren't a lot of good players so you can clean up."

What does this have to do with investing? Following Beyer's logic, it is also unwise to invest in stocks like ExxonMobil Corp. (NYSE: XOM), Goldman Sachs Group (NYSE: GS), and Wal-Mart Stores (NYSE: WMT). There are simply too many good players handicapping these stocks for us to be able to find good deals. Remember: In horse racing, the object is not to bet on the horse most likely to win: That will nearly always be the favorite. The object is to bet on the horse that offers the best risk/reward ratio -- the horse that has a better chance at winning than its odds would indicate. This is a market inefficiency, and it's more likely to be found in small-caps or small tracks than big-caps or big tracks.

James Altucher wrote a nice piece in today's Financial Times about buying stocks under $5. The most interesting tidbit from the piece:

In 2003, I was talking to Tim Melvin, an investment writer. He told me about a system he tested for 2002: each month he bought every stock on the New York Stock Exchange that was trading below $3. At the end of the month, he would sell the stocks, and then begin again the next month. "The result," he told me, "was an over 200 per cent return for 2002, the worst year in 30 years in the market."

I would never invest based on any simplistic system like this, but that's just me. But there are compelling reasons for focusing your energy on stocks trading under $5, with markets caps under two hundred million dollars, or some other metric that indicates that the company is small and unloved: professional investors aren't looking.

In his book Picking Winners, Daily Racing Forum columnist Andrew Beyer suggests that horse-players go to small out of the way tracks where there are few or no professional bettors. This way, you aren't competing against pro gamblers, and the odds are more likely to be inefficient: that is, you will have a better chance at beating the odds.

The same is true of micro-cap stocks, or stocks with low prices (in some cases...a company like Sirius Satellite Radio Inc. (NASDAQ:SIRI) is too well-followed, in my opinion, to qualify as overlooked). Many mutual funds can't invest in stocks under $5 or OTC stocks and this may mean opportunity for investors. Be careful though. These companies require TONS more research (usually straight from SEC filings because few secondary sources exist for overlooked companies).

Sunday's New York Times had a column by Paul J. Lim about the performance of large caps vs. small caps in 2006. Small cap stocks beat the big caps this year, but only because of a huge January, where small caps soared over 7%. The piece addresses the difficulty of handicapping which group will outperform. Financial planner James A. Shambo said that "the market has a tendency to do what most of us think it won't do. It loves to humiliate us."

While it seems clear that picking which category is likely to perform best in any given year is a fool's game, for long-term investors, small-caps have outperformed handily over time. For stock-pickers (which most readers of this blog probably are), it is clear that small-caps are probably the most lucrative source of opportunities. In his book Real Money, CNBC pundit Jim Cramer talks about the strategies of horse race handicapping legend Andrew Beyer, and how they can be applied to financial markets. One of his maxims is: Only go to tracks where there aren't a lot of good players so you can clean up.

The analogy here is obvious. According to the efficient market hypothesis, there are so many people analyzing the stock market all the time that stock prices are always right. Prices are in equilibrium, and the only way to earn superior returns is to take above-average risks. This theory may hold reasonably well for large stocks that are well-followed by Wharton-trained analysts and an army of hedge fund managers. But what about small stocks that are completely off the mainstream radar? Here, people who are willing to devote the time may find undiscovered gems that Wall Street analysts miss because they're too busy endlessly analyzing stocks like GE and Exxon. As Peter Lynch has said, "he who turns over the most rocks wins the game."