Small stocks may beat larger ones in the long run, but the results aren’t as consistent as we tend to assume
Cris Sholto Heaton Investment columnist
Investing is full of received wisdom and rules of thumb that are probably partly true, but not quite as reliable as we claim. Take the size effect: the theory that smaller stocks will on average outperform larger ones. Smaller stocks have greater potential to grow than larger ones, but they are riskier and so investors will value their prospects at a discount to larger firms. Put this together and you should get higher returns from small stocks, albeit with more volatility.
As is often the case, this idea is based on US data. Various studies – most famously those by Eugene Fama and Kenneth French – have found that since 1926, US small caps beat large caps by decent margins. Fama and French’s work suggests the difference has been around three percentage points per year on average.
The effect may have got smaller over time and it may not have held in all international markets. Some analysts argue that incomplete historical data on delisted stocks make the results unreliable or that greater transaction costs for dealing in small caps means this wasn’t really an exploitable opportunity to earn higher returns. Still, if you look at data for modern indexes in recent decades, there seems to be some evidence that it exists.
Back and forth for decades
The chart above shows cumulative returns on the standard MSCI indices for the UK, the US and Japan (ie, large and mid caps) relative to small caps. If the line is going up at a particular point, small caps are outperforming. If it’s going down, larger stocks are outperforming. When the line is above one, small caps have cumulatively outperformed large ones from the starting point (1993 here) to date.
These series go back just 30 years and they are calculated using price returns only (the total return index with dividen
