Small stocks are widely believed to provide higher rates of return than larger-capitalization stocks. But early research into small-stock returns failed to consider certain economic aspects of small-stock investing—namely, the extra risk and additional illiquidity associated with small stocks. These may very well explain the mysterious return to smallness.

Adjusting the returns on a broad universe of equity portfolios for risk and transaction costs gives a more realistic picture of the returns actually available to small-stock portfolios. While adjustment for risk significantly reduces the raw total returns to small-stock portfolios, transaction costs do the most damage. This result is a function, not only of the higher cost of trading smaller, less liquid stocks, but of the turnover required.

Turnover rates increase systematically as portfolio market capitalization decreases and as rebalancing frequency increases. For all but the very smallest decile of market capitalization, a strategy of rebalancing every six months results in zero or negative excess returns. The actual returns available to practicable small-stock portfolios are much smaller than those documented in previous studies and apparently expected in practice.