Small Firm Effect

Small Firm Effect

A theory stating that publicly-traded companies with low market capitalization tend to outperform larger ones. Part of the small firm effect may be explained by the fact that these firms are riskier and, therefore, have higher returns. Additionally, small firms have lower stock prices and, thus, what would be a small price appreciation for a large firm can, in fact, be huge for a small firm. See also: Neglected-firm effect.
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This result supports the theorem of "small firm effect," which argues that the smaller-cap firms tend to outperform the larger ones in the stock market, as smaller firms may have presumably greater potentials for growth and also higher risk.
It involves the so-called Fama-French Small Firm Effect, which came out of the University of Chicago in the early 1980s.
Kohers and Kohli (1991) provided evidence that the January effect is not related to small firm effect.
It follows that liquidity can help explain a number of puzzles, such as why equities commanding high required returns (the equity premium puzzle), why liquid risk-free treasuries have low required returns (the risk-free rate puzzle), and why small stocks that are typically illiquid earn high returns (the small firm effect).
Many mutual funds and institutions subsequently exploit this small firm effect by purchasing small capitalization stocks.
This revised return series appears to provide even stronger support for the investor sentiment hypothesis, but it also hints of a January small firm effect. Table 2 presents the impact of the January seasonal on the level and monotonicity of the adjusted [R.sup.2]s using the revised series.
A small firm effect of 6.12% is also consistent with the declining small firm effect since its general dissemination by Reinganum in 1979.
After reviewing the relevant literature on the small firm effect, McMahon rom.
The tendency of small firms to have greater risk-adjusted security returns than larger companies is referred to as the small firm effect. Klein and Bawa (1977) and Zeghal (1983) indicate that the availability of information may be the causal factor behind the small firm effect.
These anomalies include: the "weekend effect," where average returns from trading on Mondays tend to be systematically negative; the January effect"' which makes the average returns on all stocks positive in January; and the small firm effect'" where the risk-adjusted returns on the stocks of relatively small corporations are greater than the risk-adjusted returns for large corporations.
This "small firm effect" may cause individual investors to choose to diversify into smaller firms when they make asset allocation decisions.
The choice of the market value as a proxy variable for the thinness of a security and the relationship between intervalling effect bias in beta and thinness would suggest that the intervalling effect could explain the size or small firm effect discovered by Banz (1981).

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