West Explains Much

If my piece earlier this week on Geoffrey West’s research and the small-cap premium caught your interest at all, you may want to check out the video below in which West explains his ideas in outline.  You may also read the accompanying interview with him here.

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Size Matters: The Source of the Small-Cap Premium

Since at least 1981, when Rolf Banz published The Relationship Between Return and Market Value of Common Stocks, the idea of a small cap premium has been pretty well established.  Thus, over time (though it may take a very long time), we can expect higher average returns for common stocks of smaller companies relative to larger companies.  For example, over the period from 1927-2010, the smallest decile of U.S. stocks outperformed the largest decile by 10.4 percent annually.

The standard explanation for this premium is that small-cap stocks are inherently riskier. The idea is that small-cap stocks are more volatile and more sensitive to overall market movements; they’re also more exposed to systematic default risk and business cycle risk.  But I have a non-standard explanation to offer — one that starts with a physicist named Geoffrey West..