Question

What are the key characteristics of size anomalies?

Answer 1

In non-financial parlance, an anomaly means an unexpected, irregular and strange event which can't be explained based on the underlying theories in the relevant domain.

In financial markets, the theory of efficient market hypothesis is believed to determine the behaviour of securities, such that the valuation of stocks is based on the market participants discounting all the available information at a given point of time.

An anomaly in financial markets refers to a situation when the behaviour of certain stocks seems independent of the above criteria of efficient market hypothesis but is rather dictated by some unknown factors that can't be understood. A very simple example of anomaly in financial markets is 'Weekend effect' wherein it has been observed that the markets have historically declined on Mondays quite consistently. There are no factors or conclusive explanations that can be attributed for the above behaviour and hence its classified as an anomaly.

Characteristics of size anomalies:

Size anomalies refer to a belief that smaller companies have given higher returns than their larger peers and hence there exists a size bias in the market. Key characteristics are as follows:

• Size anomaly is often attributed to the fact that smaller companies have opportunities for higher %growths in their businesses and hence the expected returns are more than the larger peers
• Size bias is seen to have existed more between very small and large stocks. On the contrary, size bias between medium and large size firms hasn't been significant
• The size anomaly has historically been more noticeable in times of bearish market situations when the market is ready for a turnaround from a prceding crash or significant bearish movement such as that existed in 2002 and 2009
• The theorists have often attributed size anomalies to either market inefficiencies or flaws in underlying valuation models such as CAPM.
• It is not yet proved if the size is the reason behind size anomaly or there are some other unidentified causes related to size which result in size anomaly