Does poor diversification explain the small-firm effect

This dissertation shows that stock return volatility can explain the size effect because volatility is an important risk measure for undiversified investors and size is a proxy for long-term volatility. Improved diversification made volatility unimportant in the cross-section of stock returns after 1980, and caused the size effect to disappear as size is a proxy for vanishing volatility effect. Institutional investments in small firms improved diversification just before 1980, which in turn approximately halved small-firm discount rates. Poor diversification provides an economic rationale for the existence of the small-firm premium and its disappearance after risk-sharing improved.