Rethinking Risk (II): The Size and Value Effects

Abstract

Small-cap stocks are typically viewed as riskier than large-cap stocks, and value stocks as riskier than growth stocks. But are they? It depends, both on an investor’s holding period and the way he assesses risk. If an investor is concerned with volatility, either during or at the end of the holding period, then the conventional wisdom is correct. However, if an investor focuses on his long-term terminal wealth, then the conventional wisdom is turned on its head: The evidence discussed in this article strongly suggests that small stocks should be viewed as less risky than large stocks, and value stocks as less risky than growth stocks. This is the case because small and value stocks offer both more upside potential and, when tail risks strike, better downside protection than do large and growth stocks.

Keywords: Risk, holding period, lower-tail terminal wealth, time diversification

JEL Classification: G10, G11, G12