Among the most time-honored investment rules-of-thumb is the idea that small cap stocks tend to outperform large cap stocks over the long run.  Whats more, the out-performance of small cap stocks persists even after their increased price volatility is taken into account.

Why Small Cap Stocks Outperform

That small cap stocks outperform is at the core of the Fama-French Three-Factor Model. an economic theory used to describe market behaviour based on Price/Book Value (P/B).  The Fama-French model basically postulates the existence of a series of persistent risk premiums that can be used to predict relative investment returns over very long periods of time.

So why do small cap stocks tend to outperform large cap stocks over the long term?  Simplesmall cap stocks are riskier!  Smaller companies tend to be less well-established, less financially-stable, generally compete in more competitive niche markets, and are generally much more likely to go bankrupt than their larger cousins.  Therefore, investors demand a higher expected return from small cap stocks in exchange for holding them.  After all, why suffer the added risk of holding small cap stocks if they return the same as large caps?

Does this mean small cap stocks will always outperform large cap stocks, bonds, and all other asset classes?  Of course not.  There have been long periods of time in the past where large cap returns thoroughly beat those of small caps, including the famous 1982-2000 bull market.  Since 2000, however, small cap stocks have enjoyed a commanding lead.  Over long periods of time (say 50 or 60 years) its probably a safe bet that small caps will outperform; however, its far from certain.  And besides, 50 years is longer than most investors can afford to wait.  For that reason, you should maintain a diversified portfolio or large caps, small caps, bonds, real estate, and foreign stocks, just in case.

The Size Of The Small Cap Stock Risk Premium

The exact size of the small cap risk premium is subject to intense debate, but since theres no universally agreed-upon definition of what exactly constitutes a small-cap stock (is it $1 billion?  $500 million?), its nearly impossible to pin it down with any degree of certainty.  Still, most estimates peg the risk premium associated with small cap stocks at between 1-1.5% per year and the risk premium associated with small cap value stocks at closer to 2%.