Small Firm Effect
Anomalies in general are terms used to describe the situation that the actual result from an assumption is different from the expected result. This essay will discuss the small firm effect as an anomaly which counter-argues the efficient market hypothesis in relate to the capital assets pricing model. Furthermore, the supporting evidence and influence of this anomaly will be included in the essay. Moreover, the reason of existence and profitability will be discussed. At last, a conclusion about whether or not to use this anomaly earn profit will be provided.
Explanation of small firm effect and its methodologies
Small firm effect refers to a situation which the average risk adjusted returns of smaller firms are higher than the larger firms Banz(1981). This situation shows the insufficient of CAPM in predicting the stock returns and counter-argues the efficient market hypothesis Banz(1981). It was found by researching the relationship between the return and market value of common stocks in the New York Stock Exchange. The researchers build a generalized asset pricing model which adds the variable market value of security to the capital assets pricing model Banz(1981). The constant measuring the contribution of market value of a stock to the expected return of the stock was found as a significantly negative number for the all-time period Banz(1981). This indicates that the larger the market values the smaller the expected returns Banz(1981).
There are several evidences support the small firm effect as an anomaly counter-argues the efficient market hypothesis in relate to the capital assets pricing model. Under the efficient market hypothesis, no persistent excess profits can be earned on a stock by using public available information. However, the research done by Banz(1981) proves that about twenty percent risk-adjusted profits can be earned by using strategy of taking long positions in a portfolio of smaller firms and taking