The Size Risk Factor


The second risk factor in the Fama/French model is the “size risk factor,” referring to the level of a portfolio’s exposure to small company stocks. Small companies are more volatile and riskier than larger companies because they have less business diversification, fewer financial resources and greater uncertainty of earnings than their large counterparts.

The painting for the size factor contrasts General Electric with the small cap company Acme Packet. It is obvious that Acme is a riskier investment than GE, therefore the cost of capital for Acme and the expected return for its investors should be higher.

Figure 8-8 plots the risk and return of the S&P 500 Index and U.S. companies according to size over a 90-year period.

Figure 8-8

Step 8Size FactorExposureSmall Companies