A hypothesis that holds that investing in small firms (i.e., those with small market capitalization– hence dubbed: small caps) will, on average, provide higher risk-adjusted returns than investing in large caps (big caps). Empirical evidence supports this hypothesis: small-cap firms outperform larger ones. This anomaly was originally discovered by Banz (1981) who found (in a study on all New York Stock Exchange firms) that both total and risk-adjusted returns tend to fall as the firm’s market capitalization increased. This study separated all NYSE-listed stocks into categories based on shares outstanding times stock price, and examined their returns.
The average annual gain of the smallest firms was almost 20% higher than the largest ones. Later studies have shown that the small-firm effect is observed almost entirely in the first weeks of January and seems to be tied to tax-loss selling.
