Small-Stock Effect

Historically, small-company stocks have outperformed shares of larger corporations. For academics, this outperformance wasn’t, by itself, surprising. Small stocks are more volatile than large stocks, so theory suggests they ought to compensate investors with higher returns. Instead, academics were intrigued because this outperformance was greater than could be explained by small stocks’ higher volatility, as measured by beta.

The small-cap effect was detailed in a 1981 academic paper by Rolf W. Banz, then at Northwestern University (“The Relationship Between Return and Market Value of Common Stocks,” Journal of Financial Economics, Vol. 9, Issue 1). If greater volatility didn’t fully explain small stocks’ outperformance, what else was going on? It seems small-stock investors were getting rewarded for taking a risk that wasn’t reflected in volatility.

This extra reward might be compensation for the higher trading costs involved with small-company stocks or the greater risk that these companies will end up in bankruptcy, because small stocks aren’t as financially strong as large-cap stocks. Alternatively, it might be explained by the relative dearth of information available on smaller companies, in part because they aren’t widely followed by analysts.

Why does it matter whether the small-stock effect, as well as other market anomalies, can be attributed to greater risk? If there is greater risk involved, such as the chance that you’ll lose far more than the broad stock market during the next market slump and perhaps even see some of your holdings go bankrupt, the superior performance will likely continue. But if the extra return isn’t a reward for taking extra risk, there’s a good chance it will disappear as investors flock to take advantage of this “free lunch.”

The discovery of the small-stock effect spurred the 1981 launch of an index fund devoted to U.S. microcap stocks. It was the first mutual fund offered by Dimensional Fund Advisors, which sells its funds through independent financial advisors. Since then, DFA has been at the forefront of creating funds based on the latest academic research. Many other fund companies now also offer small-cap index funds, including Charles Schwab, Fidelity Investments and Vanguard Group.

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