Differential information, expectations, and the small firm effect

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Virginia Polytechnic Institute and State University


An empirical study of the effects of differential information and the expectations of investors is undertaken to test the differential information theory of Barry and Brown (1983). The theory is tested using the small firm effect. The excess returns found using ex post data are regressed against proxies for differential information and expectations. The residuals from these regressions are then tested to determine if the small firm effect is still observed.

The results of this study are:

  1. The tests provided empirical evidence that is consistent with the theory of Barry and Brown (1983) when a suitable proxy for differential information is used.

  2. For the sample studied, the differential information effect on perceived risk by investors largely explained the small firm effect, when a suitable proxy was used.

  3. Evidence was found that the small firm effect is composed of two parts supporting the findings of Keim (1983). One is a January effect, and the other during the remainder of the year, with the January effect still observed.

  4. The proxy chosen to represent heterogeneous expectations must be selected with care. In this study the one selected did not prove suitable. Reasons are provided which indicate that the proxy chosen was the principal cause of the failure of these tests to support the theory.