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What Is the Small Firm Effect?

Malcolm Tatum
By
Updated May 16, 2024
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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.

SmartCapitalMind is dedicated to providing accurate and trustworthy information. We carefully select reputable sources and employ a rigorous fact-checking process to maintain the highest standards. To learn more about our commitment to accuracy, read our editorial process.
Malcolm Tatum
By Malcolm Tatum , Writer
Malcolm Tatum, a former teleconferencing industry professional, followed his passion for trivia, research, and writing to become a full-time freelance writer. He has contributed articles to a variety of print and online publications, including SmartCapitalMind, and his work has also been featured in poetry collections, devotional anthologies, and newspapers. When not writing, Malcolm enjoys collecting vinyl records, following minor league baseball, and cycling.

Discussion Comments

By Animandel — On Oct 14, 2014

I don't know anything about managing a business and I would be the last person you would want to ask about stocks and investments. This being said, I am encouraged by what has happened over the last couple of decades or so in the business world.

There was a time when large businesses dominated the economy and financial markets, and no one else had much hope of competing against these large corporations. I am happy to see smaller firms and individuals getting to the point where they are competing with the big boys and giving them a run for their money.

By Feryll — On Oct 14, 2014

What this article says about the versatility of smaller firms makes sense. Most people think that investing in larger companies is the best way to go in terms of making money over the long haul. I understand this because a company that has grown over time and has a solid financial history is very attractive when you are trying to figure out where to invest your money.

However, I like the fact that smaller firms don't have as many people who have to sign off on decisions, so they can act faster and this can make a big difference in the business world. As they say, time is money.

By Drentel — On Oct 13, 2014

I don't own a large corporation, and I don't know how to run one. What I do own is a group of small businesses. And what I have found is that when the businesses start to grow there comes a point when they get too big for me to run effectively.

When I first started out in business I thought bigger was better, and this is true for some people, but not for me. With size comes more workers and more duties, and not necessarily more money. The bottom line for me is I want my company to be as large as it can be as long as I am able to effectively manage it.

Malcolm Tatum

Malcolm Tatum

Writer

Malcolm Tatum, a former teleconferencing industry professional, followed his passion for trivia, research, and writing...
Learn more
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