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Bloopers & Blunders: Size Effect, Volatility and Return

Explaining why small companies have higher returns than large companies, a fund manger quoted by CNNfn on April 2 1996, had the following explanation:

 "The risks are higher because these companies are more fragile enterprises, their stocks are more volatile and we would expect the return pattern on our micro-cap activity to be more volatile. Hopefully the return will compensate for the higher volatility."

Definition of micro-cap. This refers to companies that have a market cap - capitalization - of between $250 and $300 million.

Analysis

It really is a simple application of risk and reward. Investors require a compensation only for risk that cannot be eliminated, referred to as systematic/market/non-diversifiable risk. Put differently investors are going to be rewarded, through higher required returns, only for risk that cannot be diversified away. Why should the stock market reward you for risk that you can eliminate by simply holding a large portfolio of stocks?

The comment that small stocks have a higher volatility is correct, however.

Note that your book or professor might refer to required return as "expected" return. Keep in mind that this is not what the individual investor expects, but what the average consensus investor expects, also sometimes referred to as the "market" expectation.

Explanation below requires some knowledge of the Capital Asset Pricing Model (CAPM)

According to the Capital Asset Pricing Model (CAPM),

required return = return on T-bill + (market risk premium) x beta

Thus, the only source of compensation is for beta risk. You don’t get compensation for volatility, typically measured by the variance of returns, as a significant portion of it is idiosyncratic/non-systematic/diversifiable.

By Alex Tajirian