What Is the Small Firm Effect?

The small firm effect is an economic theory that supports the understanding that businesses that are either smaller in size or function with a smaller amount of market capital are in a position to effectively compete with and even outperform larger business enterprises. Within the scope of this theory, the focus is often on the opportunities that smaller, and presumably more flexible, companies have to identify upcoming trends and capture market share while larger businesses with more cumbersome internal processes are still struggling to evaluate those opportunities. While the stock issued by smaller companies may be somewhat more volatile, the small firm effect also indicates that the chances for appreciation of those shares may be superior to those stocks that are considered more stable and less risky.

In terms of the ability to capture market share, the small firm effect highlights the often leaner and more streamlined business model used by smaller firms. One of the benefits of the more simplistic model is that making decisions requires less time and fewer individuals to be involved in that process. What this translates to is the ability to perceive an opportunity in the marketplace and proceed with the development and execution of a plan to capitalize on that opportunity before larger businesses have the chance to act. Doing so means capturing market share early in the game, and hopefully holding onto that market share even when the more top-heavy firms get around to rolling out their strategies.

The small firm effect can also make a difference in the potential returns to investors. While smaller companies do not have the capital assets of larger and more established businesses, the ability to make decisions quickly and take advantage of what might be short-term events in the marketplace increases the possibility of generating additional revenue. This means that the shares of stock issued by the small firm will increase in value accordingly, making them worthy of consideration for purchase as an investment. While there is more volatility assumed by the investor, the possible returns can often balance that risk and make the purchase a good strategy for investors.

While the small firm effect is a theory that is accepted by many in the business world, there is some difference of opinion as to whether the concept is based in fact. Typically, the opposition is to the idea that the smaller firms innately have some superior opportunities to larger businesses, noting that even international conglomerates are sometimes structured to allow for making quick decisions. One benefit of the small firm effect is that it does take into consideration the idea that small firms can be competitive with their larger counterparts and as such are worth close scrutiny by investors.