Abstract: | This paper tests the hypothesis that the small-firm effect can be explained on the basis of investor preference for positive skewness. Traditional stochastic dominance methodology is extended to consider portfolios including variable weights of investment in a riskless asset. Including a riskless asset provides the result that small-firm portfolios stochastically dominate all other portfolios. This result, which is derived on the basis of 19 years of monthly returns, indicates that the small-firm effect cannot be fully attributed to tax effects, benchmark error, or incorrect assumptions of the CAPM about investor risk aversion. |