Shrinking the Size Effect

Harry Markowitz laid the mean-variance foundation for the cornerstone capital asset pricing model (CAPM). One of the most significant and persistent empirical violations of the CAPM is the size, or small-firm, effect: the average returns of small firms are much too high relative to their betas. However, the CAPM risk-return relationship should hold for the expected parameters, and statistical theory tells us that the sample parameters are not the best estimates of the ex-ante parameters. When Bayesian shrinkage is employed to the sample average returns and betas, the size effect almost completely disappears.