Long standing conventional wisdom has it that small caps exhibit a “size-effect” — they tend to outperform larger stocks in general over the long term.
I break from conventional wisdom on the subject of the “size effect”, or the tendency for small-cap stocks to outperform large caps over the long-term.
Some negligible small cap hoodoo might exist, but it pales in comparison to what really drives this Wall Street mantra: a “volatility (beta) effect”.
By isolating certain effects, the financial blogger shows that the tendency for small caps to go up (and down) more than their larger cap brethren is due mostly to the fact that they are more volatile. It’s essentially their beta that contributes to this performance. Put another way:
Because small-caps are pretty well correlated to large-caps but about 30% more volatile, when the market goes up they tend to go up more (and vice-versa). So because of the general upward bias of the market, small-caps have naturally tended to outperform large caps. That’s NOT a size effect, that’s a volatility/beta effect.
OK, fine. Does it matter? Well, kinda. In practice, if investors like to include exposure to small cap stocks in their portfolios to capture the size effect, they’re still going to get small cap performance — it just may not be as big as they may think it is and may not be due to the size of the companies they’re investing in.
If volatility is the culprit, they could theoretically do just as well by investing in larger cap, more volatile (tech?) stocks.