Definition of small firm effect

tendency of stocks of smaller firms, defined by market capitalization, to outperform larger firms. Theories to explain this phenomenon vary, but include the following: (1) smaller companies tend to have more growth potential; (2) small capitalization groupings include more companies in financial difficulty; when fortunes recover, price gains are dramatic and lift the return of the group as a whole; (3) small firms are generally neglected by analysts and hence by institutions; once discovered, they become appropriately valued, registering dramatic gains in the process. The term is also used to describe the tendency of lower priced stocks to rise or fall in greater percentage increments than higher priced shares, market capitalization, and other factors being equal.