A theory that suggests that certain neglected firms tend to outperform darlings of the day or firms that receive much more attention from large financial institutions. In other words, the neglected-firm effect maintains that small firms, usually ignored by large financial institutions (such as mutual funds, investment banks, insurance companies, etc) tend to generate higher returns than those firms focused on by financial institutions. By classifying firms into categories of highly researched stocks (highly followed firms), moderately researched stock (moderately followed firms), and neglected stock (seldom followed or neglected firms), based on the number of institutions holding the stock, researchers have found the last category outperformed the more well-followed firms.

Institutional investors sometimes focus mainly on the large-capitalization firms (large caps). Therefore, researchers and analysts do not pay as much attention to firms that are poor portfolio candidates. Arbel, Carvell, and Strebel (1983) probed 510 firms over a ten-year period and concluded that the smaller firms outperformed well-followed institutions. The researchers assumed that large institutions (and analysts) might consider the smaller firms much riskier, and consequently they overlooked them.

This abnormal occurrence is a variation of the small-firm effect, and both the neglected-firm effect and the small-firm effect postulate that market efficiency decreases as firms get smaller. Because large financial institutions may ignore these firms, their exclusion has a negative impact on the market efficiency.