The size effect is a market anomaly in asset pricing according to the market efficiency theory. According to the current body of research, market anomalies arise either because of inefficiencies in the market or the underlying pricing model must be flawed. Anomalies in the financial markets are typically discovered form empirical tests. These tests usually rely jointly on one null hypothesis H0= markets are efficient AND they perform according to a specified equilibrium model (usually CAPM). Thus, if the empirical study rejects the H0, the reason could either be due to market inefficiency or due to the incorrect model. Market efficiency theory says that the price of an asset fully reflects all current information and is not predictable (Fama 1970). Fama (1997) states that market anomalies, even long-‐term anomalies, are not an indicator for market inefficiencies due to the reason that they randomly split between “underreaction and overreaction, (so) they are consistent with market efficiency” (p. 284), they happen by chance and it is always possible to beat the market by chance. This essay will give an overview of the literature of the size effect and will stress the key theories, empirical methods and findings, as well as the existing body of research about this particular anomaly.
Table of Contents
1. Introduction
2. Empirical Methods
2. Theories and Concepts
3. Empirical Evidence
4. Reasons for the Size-Effect
5. Conclusion
Research Objectives and Topics
The primary objective of this paper is to provide a comprehensive overview of the size effect anomaly within asset pricing. The research investigates the validity of the Capital Asset Pricing Model (CAPM) in relation to the observed phenomenon that smaller firms often generate higher returns, while also examining various empirical methods and alternative explanations for this market anomaly.
- The theoretical foundations of CAPM and its limitations.
- Methodological approaches to testing market anomalies, including cross-sectional regressions.
- Empirical evidence of the size effect and its historical variability.
- Alternative risk-based and behavior-based explanations for firm size influence on returns.
Excerpt from the Book
2. Empirical Methods
The two major methods of testing the size effect are the cross-sectional linear regression or to categorize size-groups and analyse the monthly returns of each group and compare them (Fama and French 2008). Some studies use a both methods but others only use the regression method. The method of sorting companies is a very straightforward method, which presents a “simple picture” (Fama and French 2008, p. 1654). By using this method, researcher just calculate the mean returns of each group over a specific time period and compare them which each other. However, “A potential problem is that the returns on (...) portfolios that use all stocks can be dominated by stocks that are tiny“ (Fama and French 2008, p.1654).
The cross sectional regression method computes a regression on particular stocks or portfolios. One advantage of the cross-section regression is that it can estimate which “anomaly variable” (Fama and French 2008, p.1654) has what kind of influence on the returns. It is possible to compute minimal effects of each variable. Additionally, according to a diagnostics of the residuals of the regression model it is possible “to judge whether the relations between anomaly variables and average returns implied by the regression slopes show up across the full ranges of the variables” (Fama and French 2008, p.1654). In other words, you can conclude by the different slopes of the regression among the stocks/portfolios if certain anomalies like the size-effect are significant or not.
Summary of Chapters
1. Introduction: This chapter introduces the size effect as a market anomaly and outlines the core objective of exploring the theoretical and empirical literature surrounding it.
2. Empirical Methods: This section details the primary statistical methodologies used to test the size effect, specifically comparing sorting techniques and cross-sectional regression models.
2. Theories and Concepts: This chapter provides the theoretical background of the Capital Asset Pricing Model (CAPM) and explains its foundational role in assessing systematic market risk.
3. Empirical Evidence: This section presents historical data and studies regarding the size premium, noting that the observed effect has fluctuated in significance over different time periods.
4. Reasons for the Size-Effect: This chapter analyzes alternative explanations for the size effect, including multi-factor models, liquidity risks, and price adjustment delays.
5. Conclusion: The final chapter summarizes the current debate on the size effect and suggests potential directions for future research into market anomalies and asset pricing.
Keywords
Size effect, Asset pricing, Market anomaly, CAPM, Empirical methods, Cross-sectional regression, Market efficiency, Firm size, Risk premium, Systematic risk, Liquidity risk, Portfolio theory, Stock returns, Price adjustment, Financial markets.
Frequently Asked Questions
What is the core focus of this research paper?
The paper examines the "size effect," a market anomaly where small-cap stocks historically tend to outperform large-cap stocks, and investigates why this phenomenon exists and whether it challenges established pricing models like CAPM.
What are the primary thematic areas explored?
The work covers theoretical financial models (CAPM), empirical testing methodologies (regressions), historical market performance data, and potential explanations like risk, liquidity, and information friction.
What is the main objective of the study?
The objective is to synthesize existing literature to determine if firm size reliably predicts stock returns and to evaluate the robustness of this anomaly against different economic conditions.
Which scientific methods are utilized?
The paper reviews academic literature that employs cross-sectional linear regressions, portfolio sorting, multi-factor models, and diagnostic testing of residuals to analyze asset returns.
What content is covered in the main body?
The main body moves from the theoretical derivation of CAPM to its practical limitations, followed by empirical evidence from various U.S. and international studies, and concludes with modern behavioral and structural explanations for the size premium.
Which keywords best characterize this work?
Key concepts include Size effect, Asset pricing, Market anomaly, CAPM, Liquidity risk, and Market efficiency.
How does the author explain the failure of CAPM to account for the size effect?
The author highlights that CAPM assumes returns are explained only by systematic market risk, whereas empirical evidence suggests that other variables—such as firm size, book-to-market ratios, and liquidity—also influence return volatility.
What is the significance of the "delay premium" mentioned in the research?
The "delay premium" refers to the finding that smaller companies often experience delayed price adjustments to new information compared to larger firms, which partially explains why their returns appear higher in certain analyses.
- Quote paper
- Arthur Ritter (Author), 2014, Size Effect. An Overview, Munich, GRIN Verlag, https://www.hausarbeiten.de/document/289140
