Small Firm Effect

1892 Words8 Pages
Introduction
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
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stock market shows that excess returns can be earned in related to firm size but the effect is not stable over time. Dimson and Marsh (2001) believe that market anomalies apply to Murphy 's Law which if things can go wrong, it will eventually go wrong. That is, the excess return of small companies will eventually move towards reverse. They compared the stock return of small firms in the U.K. stock markets with that in the U.S. stock markets from 1955 to 1997. The study shows the stock returns of small firms were 6% higher than large firms during 1955 to 1986 then many founds Management Company launched between 1987 and 1988, followed a reverse on stock returns of small firms were 6% lower than the large firms from 1989 to 1997 (Dimson and Marsh 2001). This may also be contradicts for the small firm effect.
Reasons for existence of small firm effect
Mispricing
Some researchers explained the small firm effect as mispricing from the measurement or method error of assets price model, but Roll (1983) finds this is not the case. He believed that the frequency of trading and holding period can affect the beta estimates. The risks of small firm were undervalued and returns were overvalued for small firms in short holding period (Roll 1983). Furthermore, as small firms are traded not often, the daily stock returns were delayed, the risk was undervalued (Roll 1983). However, Reinganum (1982) use
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