The Size Premium in a Granular Economy

Abstract

We investigate how stock market concentration impacts the difference in returns between small and large firms (i.e., the size premium).  Concentration may increase expected returns for large firms due to the inability to diversify their idiosyncratic risk (i.e., granularity), but it also may increase expected returns for small firms due to capital misallocation.  We find that concentration increases the size premium by 13.33 percentage points per annum, indicating the capital allocation effect dominates. A variety of tests provide further evidence of this capital allocation effect. Nonetheless, we also find evidence that the size premium weakens following idiosyncratic increases in granularity.

Keywords: Granularity, Size Premium, Concentration, Asset Pricing, Capital Allocation,

JEL Classification: G11, G12, G14, G17