Small Minus Big - SMB

In our mind, there are three main factors that go into determining how delicious a pizza is going to be: the quality of the dough, the consistency of the sauce, and the amount of cheese. If one of those factors is off, we can still have a good pizza on our hands, but when all three of them are on point—that’s when a pizza is truly at its best.

This is the same kind of thinking that goes into the Fama-French Three Factor Model, which evaluates and describes stock market returns and portfolio performance. “Small Minus Big,” or SMB, is one of those three factors.

Think of it as the cheese from our pizza example. The SMB says that portfolios with more small-cap stocks than large-cap stocks should, in the long-term, outperform the market in general. It’s calculated by subtracting the average return on three large portfolios from the average return on three small portfolios. Or, put another way, by subtracting big from small. Small minus big.

When we look at the SMB in conjunction with the other two factors, the dough and the sauce, or, as they’re more formally known, the CAPM (Capital Asset Pricing Model) and the HML (High Minus Low), we can, some say, accurately predict how portfolios are going to behave. Just like we can use dough, sauce, and cheese to predict how good a pizza is going to taste.