Size effect

The size effect, also called the small cap effect, is the tendency of small cap shares to outperform large caps over the long term. Evidence for this looks less good than it once did.

The size effect can be explained by the illiquidity of small companies, particularly as a result of higher trading costs (e.g., because of higher spreads).

The extent of the small cap effect has varied over time, with quite long periods of over-performance and under-performance compared to large caps, which makes it difficult to assemble enough data to provide a definitive proof or disproof.

Given that the biggest weakness strategies using the small cap effect is that the real out-performance is likely to be offset by trading costs, perhaps the best advice to investors is to regard it as most relevant when constructing a portfolio of shares that they are likely to hold for the long term.

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