A hypothesis which maintains that the stock of small-capitalization firms tends to outperform the stock of larger ones. This means that investing in small-cap firms will, in general, produce higher risk-adjusted returns. Empirical studies support this hypothesis (according to a study conducted by R. Banz on all firms listed in NYSE, the returns of the smallest firms were almost 20% higher than those of the largest ones). Some analysts attribute the small-firm effect to the higher ability of small firms to grow as opposed to larger ones.

This market anomaly implies that portfolio managers should not overlook small-cap firms in the security selection process.