Monika Dutt: Size is perhaps one of the better-known factors in the investing world. There is evidence that small cap stocks outperform large cap stocks. And there are many theories on this but they all boil down to the fact that small companies are riskier than large companies. And risk is painful. It hurts. In an efficient market, investors should be compensated for accepting greater risk with higher expected returns.
Overall, small companies are less profitable, less liquid and they have less analysts covering them, which also increases their chances of being mispriced. Small caps are also more volatile. While investing in individual small caps may be risky, when you hold an entire portfolio of them, you disperse this risk and increase your chances of picking up the next Amazon at a bargain.
For these reasons, this strategy is not for the faint of heart. Even though small caps are associated with better long-term performance, they can go through years and years of underperformance, making them difficult to stick with sometimes.
What has worked in the past may also not continue working in the future. There are concerns that as liquidity increases and information moves more efficiently, the small cap premium may diminish.
