Big Picture of the Small Minus Big Anomaly
After reading through a simple understanding of the small minus big anomaly, remember that one financial strategy or term will play into others. The small minus big anomaly has a role in the Fama and French Three Factor Model.
Exposure to these methods will allow you to grow as an investor and see what makes sense for your expertise in the investing field. Keep reading to learn about the Fama and French Three Factor Model and how it takes models in academic circles even further.
What is the Fama and French Three Factor Model?
The Fama and French Three Factor Model is explains stock returns. Eugene Fama and Kenneth French cultivated this model to analyze beyond the traditional way of CAPM (Capital Asset Pricing Model). The three factors in the Fama and French three-factor model are the following,
- – Size (SMB – Small Minus Big): In this model, small-cap stocks generally have a higher return than large-cap stocks.
- – Value (HML – High Minus Low): In this model, the emphasis is placed on value stocks over growth stocks, with the specification of excess return on a high book-to-market ratio.
- – Market Risk (Portfolio’s return less than the risk-free rate of return): In this model, market risk is calculated by the excess return of the overall market over the risk-free rate.
How Does It Relate to Small Minus Big (SMB)
One of the three factors in the model is size, but specifically, an emphasis on the small minus big anomaly. Both Eugene and Kenneth discovered that small-cap stocks generally outperform large-cap companies.
Two main reasons for the success of small-cap stocks are the excess risk that small-cap stocks take on because of a higher cost of capital or when investors incorrectly price the value of the stocks, which results in higher performance.
What Can You Learn From This Model?
If you only want to invest in the big and successful, you’re limiting your options and ignoring the potential for greater returns. The Fama and French Three Factor Model will require time for the stocks to develop and grow, but with a long-term mindset, the rewards will be worth it.
You can learn from this model how there is great potential in small-cap companies. All you need is the patience to reap all the benefits. Keep up with Equities Lab’s content to learn relevant trading strategies and approaches at your pace.
