Size premium

Definition

Size premium refers to the additional return that investors expect to earn from investing in smaller companies compared to larger companies, reflecting the higher risks associated with smaller firms. This premium is often attributed to factors such as lower liquidity, higher company-specific risk, and less market visibility for smaller companies. Understanding size premium helps investors assess expected returns in conjunction with equity risk and company-specific risks.

5 Must Know Facts For Your Next Test

1. Size premium is typically observed in historical stock return data, showing that small-cap stocks have outperformed large-cap stocks over long periods.
2. The size premium can vary depending on market conditions; it may be more pronounced during economic recoveries when smaller firms tend to grow faster.
3. Investors often use size premium as a component in models like the Fama-French three-factor model, which aims to explain stock returns through size and value factors.
4. Size premium is not guaranteed; smaller companies can underperform larger ones due to specific risks like business failure or economic downturns.
5. Research suggests that size premium has diminished in recent years, leading some analysts to debate its relevance in modern investing.

Review Questions

• How does the size premium impact investment decisions regarding small-cap versus large-cap stocks?
  • The size premium influences investors by suggesting that small-cap stocks should provide higher returns due to their increased risk compared to large-cap stocks. Investors considering allocations to small companies weigh the potential for greater returns against the higher likelihood of volatility and lower liquidity. This understanding helps them create a balanced portfolio that reflects their risk tolerance and investment goals.
• Discuss the relationship between size premium and equity risk premium in asset pricing models.
  • Size premium is an important component of asset pricing models, particularly when combined with equity risk premium. While equity risk premium addresses the general risk associated with equities versus risk-free assets, size premium specifically accounts for additional risks tied to smaller firms. Models like Fama-French incorporate both premiums to better explain expected returns and help investors make informed decisions based on both company size and overall market conditions.
• Evaluate how changes in market conditions might affect the relevance of size premium for investors today.
  • Changes in market conditions can significantly alter the relevance of size premium for investors. For example, during periods of economic uncertainty or downturns, smaller companies may face greater challenges compared to larger firms, potentially reducing their expected outperformance. Conversely, in a thriving economy, small-cap stocks may benefit from rapid growth opportunities, enhancing their attractiveness. Investors must continually assess these dynamics to determine how much weight to place on size premium within their investment strategies.

Related terms

Equity Risk Premium: The equity risk premium is the excess return that investing in the stock market provides over a risk-free rate, compensating investors for taking on the higher risk of equities.

Market Capitalization: Market capitalization is the total market value of a company's outstanding shares, often used to classify companies as small-cap, mid-cap, or large-cap.

Beta: Beta measures a stock's volatility relative to the overall market, indicating its risk compared to a benchmark such as the S&P 500.