Chapter 3
Small-Cap Stocks
The SBBI 2010 Yearbook displays a graph showing the cumulative returns of different kinds of stocks and bonds since 1926. A dollar invested in the SBBI small-cap index in 1926 grows to $12,231 by the end of 2009. In contrast, a dollar invested in the large-cap index grows to $2,592 and a dollar invested in long-term Treasury bonds grows to $84.1 In assessing returns for any asset class, the natural question to ask is whether higher returns are offset by higher risks. So this chapter will compare the risk-adjusted performance of small-cap and large-cap stocks.
In the late 1970s, several researchers built a case that there is a small-cap premium even when small caps are adjusted for their greater risk. Banz (1981) was the first author to document the relationship between the size of a firm and its return. According to Banz, not only are returns on small-cap stocks higher than those on large-cap stocks, but there is an abnormal excess return when measured against the capital asset pricing model (CAPM) security market line. In a series of widely-cited studies, Fama and French show that the size effect (together with the book value effect to be discussed in the next chapter) is important in explaining stock market returns.2
Researchers established that small-cap stocks had another intriguing feature. Most of the small-cap premium occurs in one month, January. Keim (1983) was among the first studies to document this anomaly.3 Using daily data for the period ...
