risk and reward

This past year was a difficult one for small cap stocks across all geographic regions, as shown in the table below:

Of the three equity risk premiums identified by Eugene Fama and Kenneth French1, the size premium is the smallest, and thus the most vulnerable to attack. An article in the September 2011 issue of Financial Advisor Magazine2 went so far as to declare that there never truly was a small cap premium and that large cap stocks are a superior investment to small cap stocks. As we will see below the small cap premium is alive and well, and small cap stocks have a legitimate place alongside large cap stocks in a diversified equity portfolio.

Before going any further, it is important to understand exactly what is meant by a risk premium. The presence of a risk premium implies that investors can expect a higher return as compensation for the bearing of risk. In the case of small companies, it is easy to understand that these companies should have a higher cost of capital than large companies which tend to have highly-valued assets such as widely recognized brand names and deep pools of employee talent. This higher cost of capital should be paid to investors in the form of higher returns.

Fama and French obtained a quantitative measurement of the size premium (SmB = Small Cap minus Big Cap) by sorting the US equity market into deciles based on size and assigning the five smallest deciles to the “small cap” classification. For the 84 calendar years from 1927 to 2010, the average value of SmB was 3.24% with a standard deviation of 12.92%. When we apply a statistical test (the t-test) to determine if chance alone could explain the magnitude of SmB, we find that the probability of that occurrence to be less than 5% (t >2). Furthermore, if we break up the 84-year period into the two pieces before and after the publication of the Fama/French paper1, we find that the average value of SmB was 3.35% in the 1927-1992 period and 2.84% in the 1993-2010 period. Contrary to the expectation that the small cap premium would disappear once it was publicly exposed due to numerous investors acting on it and thus driving up the prices of small cap stocks, the small cap premium actually persisted.

One very important aspect of the small cap premium is the standard deviation of about 13%. A standard deviation of this size means that it would not be uncommon for small cap stocks to lag large cap stocks by 10% in a single year (a one standard deviation event which has occurred in 9 of the last 85 years). The two standard deviation event of small cap stocks lagging by 23% or more has only occurred twice (1929 and 1973) in the last 85 years. Small cap stocks have beaten large cap stocks in 47 (55%) of the last 85 years, and in the first 12 years of this millennium, small beat large in 8 years (67%).

Any argument regarding the inclusion or exclusion of small caps in an equity portfolio should consider their diversification benefits. As shown below, a simple blended large/small portfolio (in the same proportion as used in most of the IFA Index Portfolios) captured a 0.8% higher annualized return than large cap alone with a manageable 1.7% increase in standard deviation. Also visible in the chart below is the much higher volatility of small cap stocks, as the higher return of small caps comes with higher risk.

To summarize, the question an investor should ask is not "should I be in large caps or small caps?" but rather "what is a sensible blend of large and small companies that will allow me to capture a risk premium without being tempted to sell out of my portfolio when it performs differently from the Dow Jones Industrial Average or the S&P 500?" Having an exposure to small cap stocks is still worthwhile, but it should be in moderation.


1. Fama, Eugene F. and Kenneth R. French. 1992. “The Cross-Section of Expected Stock Returns.” Journal of Finance (47):427-465.

2. Gary A. Miller and Scott A. MacKillop. 2011. "Rethinking Small Caps." Financial Advisor Magazine www.fa-mag.com/component/content/article/8289.html?magazineID=1&issue=175&Itemid=73