This study examines the empirical relationship between the return and the total market value of NYSE common stocks. It is found that smaller firms have had higher risk adjusted returns, on average, than larger firms. This ‘size effect’ has been in existence for at least forty years and is evidence that the capital asset pricing model is misspecified. The size effect is not linear in the market value; the main effect occurs for very small firms while there is little difference in return between average sized and large firms. It is not known whether size per se is responsible for the effect or whether size is just a proxy for one or more true unknown factors correlated with size.

This paper analyzes a general equilibrium model of a competitive security market in which traders possess independent pieces of information about the return of a risky asset. Each trader conditions his estimate of the return both on his own private source of information and price, which in equilibrium serves as a ‘noisy’ aggregator of the total information observed by all traders. A closed-form characterization of the rational expectations equilibrium is presented. A counter-example to the existence of ‘fully revealing’ equilibrium is developed.