Size Matters: The Source of the Small-Cap Premium

size mattersSince 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.. Continue reading