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The Size Premium As a Lottery

Last Updated on 10 February, 2024 by Rejaul Karim

In a thought-provoking examination of the often-cited size effect, Richard McGee and Jose Olmo present a compelling investigation into the link between the size premium and the top-performing stocks within diverse industries. Spanning 38 pages and revised as recently as July 2019, their enlightening study introduces a novel perspective, delving into the potential lottery-style factor payoff intrinsic to the size effect.

By proposing a test rooted in a stochastic utility model and utilizing a conditional logit model to rank investment portfolios based on size, the authors have garnered unique insights into the nuanced interaction of size and industry performance. Their empirical findings challenge conventional wisdom, revealing the spurious nature of the size effect across most industries when the highest returning stock within each industry is excluded.

Moreover, this study raises compelling implications for stock selection, investment management, and the accurate specification of risk factors. With its nuanced exploration, this research reshapes the dialogue on industry momentum and asset pricing, offering perceptive analyses and implications that resonate across investment landscapes.

Abstract Of Paper

We investigate empirically the dependence of the size effect on the top performing stocks in a cross-section of risky assets separated by industry. We propose a test for a lottery-style factor payoff based on a stochastic utility model for an under-diversified investor. The associated conditional logit model is used to rank different investment portfolios based on size and we assess the robustness of the ranking to the inclusion/exclusion of the best performing stocks in the cross-section. Our results show that the size effect has a lottery-style payoff and is spurious for most industries once we remove the single best returning stock in an industry from the sample each month. Analysis in an asset pricing framework shows that standard asset pricing models fail to correctly specify the size premium on risky assets when industry winners are excluded from the construction of the size factor. Our findings have implications for stock picking, investment management and risk factor analysis.

Original paper – Download PDF

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Author

Richard McGee
University College Dublin (UCD), College of Business and Law, UCD School of Business, Michael Smurfit Graduate School of Business, Students; Smurfit Business School

Jose Olmo
Universidad de Zaragoza; University of Southampton

Conclusion

In a resounding crescendo, Richard McGee and Jose Olmo’s “The Size Premium As a Lottery” reframes the discourse surrounding the size effect, culminating in a thought-provoking synthesis of empirical findings and asset pricing paradigms.

By illuminating the intricate dependence of the size effect on top-performing stocks within diverse industries, the authors unlock profound implications for investment management and risk factor analysis. Their pioneering contribution introduces a novel perspective, unveiling the lottery-style payout inherent in the size effect and revealing its spurious nature across most industries when excluding the highest-returning stock from each.

Moreover, their asset pricing analyses demonstrate the inadequacy of standard models in accurately specifying the size premium when industry winners are overlooked in the construction of the size factor. The implications of this research ripple through the investment landscape, reshaping industry momentum and prompting a revaluation of risk factors and stock selection.

In its denouement, this study stands as a testament to the transformative power of nuanced empirical analyses in elucidating the enigmatic dynamics of asset pricing and investment strategies.

Related Reading:

Industry Long-Term Return Reversal

Explaining the Recent Failure of Value Investing

FAQ

What is the main focus of the paper “The Size Premium As a Lottery” by Richard McGee and Jose Olmo?

The main focus of the paper is to investigate the dependence of the size effect on the top-performing stocks within various industries. The authors propose a test for a lottery-style factor payoff based on a stochastic utility model for an under-diversified investor. Through empirical analysis, they aim to shed light on the nuanced interaction between the size premium and industry performance.

What is the key methodology used in the paper to assess the size effect and its dependence on top-performing stocks?

The authors utilize a stochastic utility model and propose a test based on a conditional logit model to rank different investment portfolios based on size. The conditional logit model is employed to assess the robustness of the ranking when the best-performing stocks in each industry are either included or excluded from the sample. This methodology allows them to explore the lottery-style payoff intrinsic to the size effect.

What empirical findings does the paper reveal regarding the size premium and industry performance?

The empirical findings suggest that the size effect has a lottery-style payoff, and it is spurious for most industries once the single best-returning stock in an industry is excluded from the sample each month. The analysis challenges conventional wisdom regarding the size premium, especially when considering the influence of the top-performing stocks within industries.

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