A Test Of The Differential Information Hypothesis Explaining The Small Firm Effect

Abstract

Previous research has shown that, on average, small firms earn higher risk-adjusted returns than large firms. So far there has been no satisfactory empirical explanation for this pricing anomaly. Theoretical research has shown that firms for which less information is available should, ceteris paribus, earn higher returns to compensate for estimation risk. Since, on average, less information is available for small firms, this is a possible explanation for the small firm effect. Using the number of articles in the Wall Street Journal as a measure of information availability, I find that the small firm effect can be entirely explained by differential information availability among firms.