Does Size Really Matter?

ver since its discovery by Banz (1981), the size effect has remained an enigma. Although the empirical fact that firms with low market values earn higher returns than firms with high market values is beyond dispute, a theoretical explanation of this regularity has eluded the profession for almost 15 years. Because this empirical regularity is almost universally interpreted as evidence that small firms have higher expected returns than large firms, it has sparked a sometimes-heated debate that on occasion has even spilled over into the popular press (e.g., the Economist 1992). Theorists point out that no present theory can explain why small firms earn higher returns. Empiricists, on the other hand, point smugly to the seemingly unequivocal empirical evidence. What is the solution to this enigma? Both sides of this debate are correct. No theoretical explanation of why small firms earn higher returns exists, because none is needed. If the size of firms is measured correctly, no evidence exists that shows small firms earn higher returns than large firms. Yet, this finding is not inconsistent with the empirical fact that firms with low market values earn higher returns than firms with high market values. Modern financial theory predicts that when there is no relation in the economy between firm size and return, the relation between firm market value and return will be negative; that is, firms with small market values will have higher expected returns.