small-firm effect

Small-firm effect

The tendency of small firms (in terms of total market capitalization) to outperform the stock market (consisting of both large and small firms).
Copyright © 2012, Campbell R. Harvey. All Rights Reserved.

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.
Farlex Financial Dictionary. © 2012 Farlex, Inc. All Rights Reserved

small-firm effect

The theory that the stock of small firms tends to outperform the stock of large firms. Some analysts attribute the small-firm effect to the fact that small firms have more room to grow than large firms do.
Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David L. Scott. Copyright © 2003 by Houghton Mifflin Company. Published by Houghton Mifflin Company. All rights reserved. All rights reserved.
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Liquidity can thus play a role in resolving a number of asset pricing puzzles such as the small-firm effect, the equity premium puzzle, and the risk-free rate puzzle.
A number of researchers have found that the turn-of-the-year effect in stock returns is related to a small-firm effect (see Keim, 1983; Reinganum, 1983; Roll, 1983; and Cho and Taylor, 1987).
To empirically examine the relation between the small-firm effect and the January anomaly in the corporate bond market, I use Compustat data to compare firm market value to minor bond rating categories (see Table 3).
Given the relation between firm size, as measured by market value, and bond rating, the results suggest that the January effect in the bond market is indeed related to the small-firm effect, as also found in the stock market.
Their results suggest that both the discount anomaly and the small-firm effect are partially attributable to changes in investor sentiment.
CLST infer from these results that investor sentiment partially explains both the closed-end fund discount anomaly and the small-firm effect.
This model not only reflects the influences of some of the additional terms in the small enterprise utility function proposed in this paper, but also deals with the apparent existence of the small-firm effect. In the world contemplated by Levy (1990), an investor in a particular market segment would only acquire investments available in that segment and would necessarily hold an undiversified portfolio, which is not efficient in the sense of representing the highest expected return for the level of risk faced or the lowest risk for the level of expected return.
Levy (1990) then shows mathematically and empirically that if the CAPM is used as the benchmark for testing, either of these conditions would make the small-firm effect appear to exist.
Thus, Levy's (1990) GCAPM not only accommodates the lack of diversification that is common amongst small enterprise owner-managers and the immobility of their financial and human capital, but also provides an explanation for the puzzle of the small-firm effect. Moreover, it accomplishes these most desirable ends as far as small enterprise financial management is concerned without seriously compromising the simplicity and elegance that has made the CAPM a cornerstone of existing financial theory.
Indeed, it may be that some of the documented stock-price anomalies (such as the small-firm effect) are substantially affected by the holding period selected.

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