Journal of Financial Economics 17 (1986) 113-142.

North-Holland

EVENT STUDY METHODOLOGIES AND THE SIZE EFFECT *

The Case of UK Press Recommendations

Elroy DIMSON and Paul MARSH

London Business School, Regents Park, London N WI 4SA. England

Received March 1984, final version received December 1985

This study of 862 press recommendations demonstrates that the size effect can distort longer-term
performance measures, and hence event studies. Relative to similar sized companies, post-publica-
tion performance is neutral. However, market adjustments, the CAPM and Market Model, with
equally or capitalization weighted indexes, all produce biased results. Event studies are most
exposed to such bias when the measurement interval is long, event securities differ systematically
in size or weighting from the index constituents, the size effect is large and/or volatile, and when
CAPM-type methodologies are used. These distortions are avoided by explicitly controlling for
size.

1. Introduction

Empirical research has played a vital role in the development of financial

economics. A frequently used procedure in empirical work has been the event
study. This paper focusses on event study methodology in the presence of the
size effect, using an original study of newspaper recommendations as a
cautionary tale. The paper has twin objectives. First, it presents evidence that
the size effect can distort longer-term performance measures and hence event
study results, unless it is explicitly taken into account in research design.
Second, using a methodology which takes account of the size effect, it presents
evidence on the efficiency of the UK stock market with respect to press
recommendations.
Many investors follow press advice closely, and trading volume is substan-
tially higher around the date of a recommendation [see Stanley, Lew.ellen and
Schlarbaum (1980)]. The performance of press recommendations is monitored

*We are grateful for the helpful comments of Dick Brealey, Stewart Hodges, Clifford Smith.
Marc Reinganum (the referee), and finance workshop participants at the London Business School.
Stockholm School of Economics, European Institute for Advanced Studies in Management
(Brussels), European Finance Association (Manchester), and the Western Finance Association
(Vancouver). We would also like to thank Ramin Hakimneiad, Tamara Harrison and staff of the
Consumers Association for data collection and verification. Financial support was received from
the Consumers Association.

0304-405X/86/%3.50 9 1986, Elsevier Science Publishers B.V. (North-Holland)

114 E. Dimson and P. Marsh, Event studies and the sire eflecr

by brokers [e.g., Seymour Pierce (1984)], consumer groups [Which (1968,1983)].

researchers [Firth (1972)], and competing tipsters [Davis (1979)]. If success can
be demonstrated, tipsters use this to make aggressive advertising claims. UK
press recommendations thus provide an interesting opportunity for an event
study to test whether financial journalists provide valuable information to
investors.
There is a substantial related literature on stock recommendations by
brokers and advisory services [for a review, see Dimson and Marsh (1984)]. In
contrast, little has been published on press recommendations. Davies and
Canes (1978) observe a short-term price adjustment of 1 percent ( - 2 percent)
when the Wall Street Journal reports consensus purchase (sale) recommenda-
tions, but they do not look beyond 20 days after publication. Foster (1979)
provides a similar analysis, but with only a very small sample. The only
previous UK studies are Firth (1972) and Which (1968), both of which are
methodologically flawed and employ small samples. The evidence on longer-
term profitability is fragmentary and dated [see Colker (1963)]. No published
study examines both short- and long-run performance. A careful study thus
seems relevant.
The standard event study methodology involves the use of Sharpes (1963)
market model, as in Fama, Fisher, Jensen and Roll (1969) or of alternative
adjustments for market movements such as the ex post forms of the Sharpe
(1964) - Lintner (1965) - Black (1972) capital asset pricing model (CAPM).
Questions have been raised regarding the integrity of this approach, since it is
recognised that event studies entail a joint hypothesis about market efficiency
and the validity of the benchmark employed. Nevertheless, most research in
this area suggests that simple adjustments for market movements are usually
adequate. In simulated event studies, the gains from using more complex
models appear small. Indeed, Brown and Warner (1980) conclude that be-
yond a simple, one-factor market model, there is no evidence that more
complicated methodologies convey any benefits. Most event studies therefore
continue to use the CAPM or market model. Alternative benchmarks are used
only in studies where the stocks come from a single industry, e.g., Collins and
Dent (1978) and Dyckman and Smith (1979).
However, there has been a burgeoning literature on the importance of other
factors in the return generating process. These extra-market factors include
company size [see Banz (1981) and Reinganum (1981)], potential for tax-loss
selling [see Keim (1983) and the references in Schwert (1983)], dividend yield
[see Litzenberger and Ramaswamy (1979,1982) and Miller and Scholes (1982)],
price-earnings ratio [see Basu (1983)], maturity of the company [see Barry and

For example, if you had invested fl,OOO in the 1957 Nap Selections, and reinvested the
proceeds at the end of each year in the new annual selections, your initial f1.000 would now be
worth f251.211 (before gains tax and expenses) against a mere f1.841 if you had invested in the
FT Index. (IC Newsletter advertisement, Financial Times, November 1979)
 E. Dimon and P. Marsh, Ecent srudies and rhe sr:e effect 115

Brown (1984)], and a wide variety of other factors. The most important
empirical regularity so far observed is the size effect (the tendency for small
capitalisation stocks to outperform their larger counterparts) and the tum-of-
the-year effect (the tendency for outperformance to occur at the beginning of
the tax year). Consequently, as Beaver (1981) and others point out, an event
study which focuses on smaller (larger) firms is likely to witness positive
(negative) abnormal returns relative to the market index; this is potentially
exacerbated by event date clustering at the turn of the year.
At first sight, Beavers view seems at variance with the evidence from the
Brown and Warner (1980,1985) simulation experiments. However, Brown and
Warner are careful to point out that their studies are based on randomly
selected samples which are designed not to have marked exposure to extra-
market factors. Methodologies which are reliable for such representative
groups of securities may nevertheless perform poorly for samples which differ
substantially from the market index, and which, in the absence of an event,
exhibit abnormal performance. Where these problems are likely to be severe,
Schwert (1983) points out that event studies should give explicit consideration
to the size effect. Yet very few studies make any attempt to do so.
Schwert (1983) also argues that when the market model is used the size
effect is not a problem. The assumption here is that market model alpha
estimates encapsulate any size effect. However, the use of historical alphas
introduces considerable noise, and both Brenner (1979) and Brown and
Warner (1980) find the market model the least efficient of the standard event
study methodologies. More seriously, we know that the small-firm effect varies
considerably over tune and, for US data, exhibits a turn-of-the-year seasonal
[see Keim (1983) and Brown, Kleidon and Marsh (1983)]. Thus, if events are
clustered in a particular calendar time period, the mean size effect may differ
between the estimation and predictions periods, introducing bias into the
market model alphas. A similar problem will arise from seasonality in the
event dates, if this coincides with a seasonal in the size effect. For these
reasons we cannot assume that the market model fully resolves the problems
introduced by the size effect.
Like its American counterpart, the UK size effect is very marked. The
difference between the compound annual rates of return on the Dimson-Marsh
(1985) equal weighted and capitalisation weighted indexes was some 7 percent
over the 30 years (1955-84) covered by the London Share Price Database
(LSPD). The magnitude of the small-firm premium varies considerably from
year to year: Levis (1985) estimates that it is nearly as volatile as the return on
the underlying small stocks, though he tinds no evidence of US-type seasonal-
ity. While the UK size effect remains an empirical regularity for which only
partial explanations have been offered [see Reinganum and Shapiro (1984) and
Dimson and Marsh (1984b)], it is nevertheless too large to be dismissed, for it
may well dominate the results of empirical studies of stock returns.
116 E. Dimon and P. Marsh, Eoenr studies and the si:e eflect

The size effect does, in fact, appear to be a major influence on estimated

abnormal returns in this study. When a capitalisation weighted index is used
as a performance benchmark, financial journalists appear to exhibit long-term
predictive skills; with an equally weighted index the pattern is reversed and
tipsters appear to perform very poorly; and when the market model is used,
the results are influenced by the choice of estimation and test periods. When
we control for the capitalisations of recommended stocks, however, perfor-
mance appears to be neutral. Thus the choice of methodology, index and
weighting scheme are all critical in this study, and explicit consideration has to
be given to at least one additional factor, namely company size, when
longer-term performance is being evaluated.
The plan of our paper is as follows. The sample and data are described in
section 2, and our experimental design is presented in section 3. In section 4
we evaluate performance using a variety of alternative methodologies, and
demonstrate the importance of controlling for size. Finally in section 5, we
identify some of the broader implications of our results.

2. Sample and data

Our sample covers stock recommendations published in regular features in
the national press from 1975 to 1982. These fall into two groups. New Year
Tips appear in late December/early .Ianuary, and consist exclusively of
purchase recommendations. Portfolio Tips, on the other hand, appear
throughout the year in journals which run paper portfolios, and include advice
on sales as well as purchases. In total, 862 recommendations are identified
from eleven publications which give regular, unambiguous buying or selling
recommendations. The sources, and the percentage of total recommendations
from each, were the Economist (6%) and Investors Chronicle (IS%), which are
financial journals; the Sunday Telegraph (6%), Observer (6%) Sunday Times
(4%) and Sunday Express (2%), which are all Sunday papers; the Daily
Telegraph newspaper (12%); the IC Newsletter (7%) and the Fleet Street
Letter (3%) the two leading stock market letters; and finally three investment
magazines, namely Financial Weekly (2%), Mr. Bearbull (a pseudonym for
regular staff reporters writing in the Investors Chronicle) (34%) and Money
Observer (2%).
The portfolio tips come exclusively from the final group of investment
magazines, and make up 38 percent of our sample. They include fewer sale
(70) than purchase (253) recommendations, since sales can be selected only
from the current portfolio, and also because new paper portfolios are initiated
periodically, while termination of the old portfolio is not interpreted as a sale
recommendation. The remaining nine sources provide New Year buying
recommendations. These generally have a one-year horizon, although the
 E. Dimon and P. Marsh. Event rrudies and the sm efecr 117

Sunday Express tips were given as shares for the decade. Our sample is
distributed fairly evenly over time, with most years containing around 100
tips. [See Dimson and Marsh (1948b) for more details.]

2. I. Characteristics of recommended stocks

Our major focus is on whether the size effect, or indeed other extra-market
factors, can have a distorting impact on event studies. Clearly such difficulties
will arise only if our sample differs significantly in its weighting on such
factors from the performance benchmark. In this section, we therefore com-
pare various characteristics of our sample both with the overall market and
with the Financial Times-Actuaries All Share Index (FTA). This capitalisation
weighted index embraces over 90 percent by value of the UK stock market,
and is used as the benchmark in all previous UK event studies.
Our sample is not, in fact, representative in terms of the factor of prime
interest, namely company size. To investigate this, we rank all UK stocks by
their capitalisation at the previous year-end, and assign them to deciles
containing equal numbers of stocks. The highest two deciles by market
capitalisation contain over half (36 and 19 percent, respectively) of the
recommendations, and the next two deciles contain a quarter (14 and 8
percent, respectively). A small proportion (6, 7 and 5 percent) are in the next
three deciles, while only very few tipped stocks (3, 1 and 1 percent) are in the
smallest capitalisation classes.
Tipped stocks are four times the size of a typical UK share. However, while
recommendations are more likely to be for large companies, the probability of
a stock being tipped is less than proportional to its capitalisation. Although 36
percent of tipped stocks come from the largest decile, this decile accounts for
83 percent of the value of the FTA Index. Similarly, although nearly half of
the tipped stocks come from the bottom eight deciles, these deciles account for
8 percent of the Index value. In terms of capitalisation, therefore, recom-
mended stocks are typical neither of an equally weighted nor a capitalisation
weighted index, a feature which assumes considerable importance in our
empirical work.
Recommended stocks may, of course, be non-typical. in terms of factors
other than capitalisation. We therefore examine our sample in terms of a
representative set of factors which the literature suggests may play a role in the
return generating process, namely, industry, yield, beta and residual risk. This
analysis identifies no extra-market factors, other than size, which warrant
special attention [see Dimson and Marsh (1984b)]. Our sample is therefore
particularly suitable for investigating the impact of the size effect on event
studies.
118 E. Dmson and P. Marsh, Event srudies and the see effecl

2.2. Share price data

Three index series are used in the study. Our initial proxy for the market, in
estimating both betas and abnormal returns, is the capitalisation weighted
FTA Index. Index returns are calculated by incorporating the published
dividend yield [see Marsh (1979)]. As an alternative market proxy, we use the
Dimson-Marsh (1985) equally weighted (EW) Index of monthly returns
(including di vi d en d s) on all UK listed shares. As a benchmark for measuring
size-adjusted performance, we also employ the Dimson-Marsh (1985) size
decile indexes. These measure the returns on the ten percent of companies
with the highest market value, the next decile by market value, and so on to
the ten percent of companies with the lowest capitalisation. The capitalisation
deciles are constructed by ranking all stocks in the EW Index by their
end-November capitalisations. Ranked stocks are assigned to deciles, and
equally weighted returns are computed for each decile over the twelve-month
period commencing with the end-December quotation, employing the same
methodology used to calculate the EW Index. By construction, therefore, the
average of the decile returns equals the return on the EW Index.
Returns on the event securities are calculated using monthly data from the
LSPD, utilising middle-market quotations prices, exactly as in construction of
the EW and size decile indexes. The initial performance of the recommended
stocks is computed relative to the (specially collected) selection-date price,
while subsequent performance is evaluated using month-end prices.3
The betas of recommended stocks are estimated relative to both the capi-
talisation weighted FTA and the EW Index, using two different estimation
methods. First, betas are computed relative to the FTA using the trade-to-trade
method to avoid thin trading bias. This involves calculating returns from dated
transaction prices, and regressing these on index returns measured over the
same calendar period. This requires daily observations on a market index
which suffers from negligible thin trading [see Marsh (1979)]. Because the FTA
Index meets this criterion [see Dimson (1979)], this method is expected to
produce efficient, unbiased beta estimates [see Dimson and Marsh (1983)j.
Unfortunately, this approach cannot be used to estimate betas relative to the
EW Index, since directly observed daily EW Index values are not available.

For the purpose of computing abnormal returns from the intra-month recommendation date to
the month-end, we estimate a series of daily values for the EW and size decile indexes. We regress
the monthly index returns on the FTA, apportioning each months residual return equally to each
trading day within the month, and then add this to the expected index return, conditional on the
daily FTA index return [see Dimson and Marsh (1984a. sect. 3.2)].
3 When returns are computed from the selection date to the end of the recommendation month,
the period in fact runs to the end-month trading day immediately following publication. Thus, the
initial performance of a tip selected on. say, Friday, 29 December and published on 30 December
would be evaluated to the last trading day of January; and similarly, post-publication returns
would be measured from the end of January until a subsequent month-end.
 E. Dimson and P. Marsh, Ecent studiesand the size effect 119

(Even if they were. they would suffer from significant thin trading bias, since
the quotations for smaller companies are not continuously updated.) The
aggregated coefficients method, which provides unbiased, but less efficient,
estimates is therefore selected as the next best alternative. Following Dimson
(1979) we use one leading and five lagged market return terms.
Stocks may attract the attention of tipsters after a period of unusual
performance. To avoid bias in parameter estimates of beta, and of course
alpha, we must exclude all prior months in which abnormal returns occur.
Since returns might reasonably be expected to trigger a recommendation
within a year, we initially exclude data for the twelve-month pre-tip period,
estimating alphas and betas over the 60 months prior to this exclusion period.
We also examine the impact of both lengthening and shortening the exclusion
period (see section 4.3.4 below).

3. Research design

3.1. Abnormal returns and the size effect

The abnormal return on a security is the difference between the realised
return and an appropriate benchmark. We define the abnormal return uls, of
security j from the start of period s to the end of period t as

ujst= Rjst- E(Rjst).

The ex post security return, RjsI, is conditional on experiencing the event
being studied, while the expected return, E( R,,), is the return expected in the
absence of the event. The power of an event study methodology depends
crucially on the quality of the benchmark, E(R,,). This is one reason for the
proliferation of methodologies in the literature [see Beaver (1982, app. A)].
Whichever benchmark is selected, event studies invariably investigate market
efficiency by testing the hypothesis that E(u,,l@~_,) = 0, where Qs_., is the
information set available at the end of period s - 1. A key concern of this
paper is the robustness of this approach in the context of the size effect. If the
benchmark fails to impound the size effect, the residual return from (1) is
correlated with the capitalisation of stock j at the end of period s - 1. This
poses the serious dilemma that the abnormal return will be negatively
correlated with, and can thus be predicted from prior information on the
stocks relative capitalisation.
Clearly, if the benchmark expected return fails to reflect the size effect,
abnormal performance estimates will be biased for all except average capitali-
sation securities. However, the mean abnormal return estimate ( uXI= X:u,,JN
for the sample of N securities) may still be unbiased. This will be the case in
periods or markets where the small firm effect is negligible, or in studies where
the event securities have the same mean capitalisation, or are weighted in the
120 E. Dm~~on and P. Marsh. Event stzuhes and the sire effect

same way as the securities in the market index. u,, will also be unbiased if the
benchmark expected return adequately controls for the size effect. Finally,
even when bias is present, its magnitude will depend on the length of the
observation period. Over very short periods, such as the days or even the
month immediately following an event, bias from benchmark misspecification
is likely to be small, relative to event-related returns and noise. As the
observation period is extended, however, the bias will be magnified, so that
over longer periods, it becomes dominant and assumes (apparently) economi-
cally significant proportions.
If the size effect is in evidence, then serious bias in longer-term performance
measures can potentially arise either from an improper choice of methodology
or from an unsuitable choice of index or weighting scheme. For example, the
choice between the CAPM or market model, or between an equally or market
value weighted index, is no longer simply a question of balancing theoretical
considerations against statistical efficiency. Rather, this decision becomes a
key component of the experimental design.

3.2. Alternative benchmarks employed

To study the impact of the size effect on abnormal performance we use three
groups of benchmarks. First we consider the usual market indexes with
standard risk adjustments. Second, we develop two size-adjusted methods,
based on control portfolios. Finally, we examine the market model.

3.2.1. Market indexes and the CAPM

Two types of benchmark are likely to suffer from the biases described
above. The first is a market index which fails to match the size exposure of the
event securities. The second is a risk-adjusted version of this, whereby the
index is adjusted to have the same beta as the event securities. The latter is
illustrated by the Sharpe (1964) - Lintner (1965) CAPM, by Blacks (1972)
two-factor model and by the Watts (1978) - Banz (1981) arbitrage portfolio
techniques. AI1 these beta-adjusted methods suffer in the same way from the
size effect, and we proxy them by the CAPM.
Given the choice between the capitalisation weighted FTA and its equally
weighted counterpart, our first four approaches are thus as follows:

j*t = Rjst - Rapt (FTA Index only), (2)

jst = Rjst - (I- fij,)Rfs,-- j3j,R,,, (CAPM using FTA), (3)

Uj,, = RjJt - R csr (EW Index only), (4)

jst = Rjsr - (1 - bje) R,st - $jeRest (CAPM using FTA). (5)

 E. Dimon and P. Marsh. Event studies and the si:e effect 121

In these equations, R,s, is the return on Treasury bills, .R,,, and R,,, are
the returns on the PTA and EW Indexes respectively, and /3,,,, and &. are the
security betas estimated relative to these two indexes (see section 2.2 above).
These equations represent widely used, standard event study methodologies
which assume a zero size effect. They differ simply in whether they use the
capitalisation weighted PTA [eqs. (2) and (3)] or the equally weighted EW
Index [eqs. (4) and (5)], and in whether beta is assumed equal to unity [eqs. (2)
and (4)] or is estimated using OLS [eqs. (3) and (5)].

3.2.2. Size-adjusted performance

One method of adjusting for the size effect is to construct a set of diversified
control portfolios for companies in different capitalisation classes. This ap-
proach has been used for factors other than capitalisation by Black and
Scholes (1973) and others. Given its capitalisation, each stock j is assigned to
its control portfolio i(j). The two forms of size control used here are

(size control only), 6)

(sizeandbeta).
In eq. (6), the abnormal return on stock j is measured as the difference
between the stocks return and the return on its control portfolio, RiCjjsr,
represented by the size decile which includes constituents with approximately
the same capitalisation as the event security. In eq. (7), this method is modified
by blending the control portfolio with the market portfolio plus Treasury bills,
to replicate the beta of the event securities. The abnormal return therefore
equals the difference between the CAPM-adjusted performances of stock j
and of portfolio i(j), thus purging the CAPM method [eq. (3)] of any size bias
in the u~,~.~
The size control portfolio approach ensures that E(u~,,]@~_,) = 0, where
QX_, incorporates information on the stocks capitalisation. The estimated
abnormal returns thus reflect the performance of similar sized companies
during the period (s, t).

4This is consistent with the genera&d asset pricing model suggested by Banz (1981), in which
expected excess returns are postulated as a linear function of both beta and capitalisation. Other
forms of size control may also be devised. For example, the u,,, may be specified as the difference
between R,, and the return on the control portfolio, where the weights given to the control
portfolio constituents are set so as to equate the portfolio beta to that of the event security [see
Banz (1981)]. These variants produce similar results to eq. (7) and are not analysed here.
122 E. Dmson and P. Marsh. Event studies and the si:e effect

3.2.3. The market model

If the size effect were constant over time, it would be unnecessary and
unduly restrictive to devise control portfolios. An alternative would be to use
Sharpes (1963) single index market model (SIMM). With a constant size
effect, the superior performance of small stocks would be reflected in their
estimation period returns and hence in their alpha estimates. These estimates
could then be used to compute prediction period expected returns which
encapsulate the size effect. The expected value of the mean abnormal return
(u,,) should be zero, since each set of stocks acts as its own control. This will
still hold true with a stochastic size effect, as long as its average magnitude is
the same over the (set of) estimation and prediction periods. This should tend
to be the case for events spread randomly over a very long calendar period.
We implement this approach using both the capitalisation weighted FTA
and the equally weighted EW Index. By regressing event security returns on
the chosen index and assuming the parameters to be stationary, we estimate
the expected return conditional on index movements. Denoting the alpha of
stock i relative to, the FTA by &+,, the predicted return on stock i in period T
is simply I?~,,,+ ,B/,,,Rq7,. The difference between the actual and predicted
return is R,,, - B,, - /3,,R,,,. If this prediction error is cumulated over time,
we obtain the prediction error for stock j over the period (s, t):

Ujrt = ,Q (1+Rjm- jm - bj,,,R,,,) - 1 (SIMM using FTA), (8)

uj,, = n (1 + Rj,
T-S
- ;yie - bj,R...) - 1 (SIMM using EW) . (9)

Approaches other than the market model [i.e., eqs. (2) to (7)) measure the
economic gain from holding the event securities in preference to (or in
conjunction with a short position in) an alternative benchmark portfolio. In
each case, the benchmark represents a viable investment strategy, comprising
pre-specified holdings in one or more published indexes, blended, if necessary,
with borrowing or lending. By contrast, the market model benchmark does not
conform to any possible, pre-specifiable investment strategy, and market
model abnormal returns can be interpreted only by invoking notional agree-
ments between hypothetical investors [see Scholes (1972)]. The SIMM is thus
primarily a statistical device, and is more suited to testing for the existence of
abnormal returns than to establishing their economic magnitude.
Other variations on the market model approach involve forcing the betas to
take specific values. For example, if betas are forced to be zero, this is
equivalent to Masulis (1980) mean adjusted returns method. This approach
 E. Dmson and P. Marsh, Ecenr studies and rhe sr:e effect 123

has strengths and weaknesses which are similar to those of the SIMM and
consequently it is not evaluated here.

3.3. The observation period and methocis of averaging returns

Our observation periods are based on units of one year. This seems
appropriate since two thirds of our sample are New Year tips which are, in
general, evaluated by the tipster one year later. However, to allow more than
sufficient time for tipsters projections to come to fruition, we extend the
post-event observation interval to 24 months. The pre-event period is also set
at one year, an interval long enough to detect a tendency to recommend stocks
after unusual price behaviour.5
The method used for computing average (i.e., portfolio) returns is a critical
part of event study design. Most studies compute cumulative abnormal returns
(CARS) by cumulating the mean portfolio abnormal returns per period over
time [see Beaver (1982, app. A) for a review of alternative approaches].
However, as shown by Roll (1983) and Blume and Stambaugh (1983), and
much earlier by Fisher (1966), the CAR can be an extremely misleading
measure of the economic magnitude of performance. This is because the CAR
represents the return on a portfolio which is reweighted every period, to give
equal dollar exposure to each constituent. This frequent reweighting means
that any price measurement errors from intraspread price fluctuations, price
rounding, untimely quotations and source document errors can induce spuri-
ous abnormal returns where, in reality, none are attainable.6 The briefer the
measurement interval (e.g., daily rather than monthly returns) and the longer
the observation period, the more biased is the CAR, relative to the equivalent
buy-and-hold return.
In our study, the long pre- and post-event observation periods create a
strong preference for buy-and-hold returns. With one exception, portfolio
returns are therefore calculated on a buy-and-hold basis, with no reweighting
except to reinvest the proceeds of delisted securities. Benchmark returns for
the FTA, and also the intra-year returns for the EW and size decile indexes are
also buy-and-hold, with no month-to-month rebalancing [see Dimson and
Marsh (1985)J. Performance is therefore measured in eqs. (2) to (7) over a

The annual observation periods were also chosen to mitigate any seasonal small-firm or
turn-of-the-year effect [see Keim (1983) and Lakonishok and Smidt (1984)]. In practice, however.
the UK size premium displayed no such seasonality over the period spanned by this study [see
Dimson and Marsh (1984b)].
Reweighting involves reducing the holding in stocks which have apparently appreciated and
increasing the holding in stocks which have apparently depreciated. When price measurement
errors are later rectified, the portfolio return is enhanced as a result of the previously reduced
holding in (spuriously) overpriced stocks, and the previously increased holding in (spuriously)
underpriced stocks.
124 E. Dimon and P. Marsh. Event studies and the six effect

single holding period (s, t) corresponding to the desired observation interval.

The only exception is in our use of the market model. Here we compute CARS
and hence implicitly reweight our event portfolio every month. Conse-
quently, our measures of abnormal performance may be misleading for the
reasons described above. However, no published studies have used a buy-and-
hold benchmark based on the market model. Accordingly, for comparability,
we too report market model CARS.

3.4. Significance testing

The abnormal returns defined above are either the difference between an
ex post return RjJt and its expectation [eqs. (2) to (7)] or a CAR [eqs. (8) and
(9)]. We assume both the realised return and its expectation are lognormally
distributed. By the central limit theorem, the CARS are approximately nor-
mally distributed. However, the buy-and-hold abnormal returns [eqs. (2) to
(7)) will not be normally distributed, especially when measured over long
periods. Consequently, their statistical significance is evaluated using the
following measure:

vst= Rst- Em 00)

where R,, = log,(l + R,,) and Es, = log,(l + E( R,,,)) and where the bar
signifies the equally weighted mean over all N securities. When the market
model is used [eqs. (8) and (9)], v,, is equated to u,(, the mean CAR for the
sample.
The variance of this performance measure is estimated from the single-period
abnormal performance, v,, = v,, - v,,_ t. It is equal to

var( v,,) = T va(v,,), 01)

where T = t - s + 1 is the length of the holding period over which performance
is measured. The variance of the v,, is estimated from event time returns over
the observation period, but excluding pre-event and event month data. The
assumption here is that the market response to the tip occurs in the recom-
mendation month, and that pre-tip data should be excluded, since tipsters may
tend to recommend stocks after unusual price behaviour.

It is possible that the abnormal performance measures, u,,. exhibit serial dependence, either
because of thin trading bias, or because New Year tips occur in both December and January, so
that event month t for one stock can correspond to event month t - 1 for another. However, we
ftnd no evidence of serial dependence and hence make no adjustment to eq. (11) [see Ruback
(1983)]. Similarly, because the portfolio constituents scarcely change in event time, and because
the pre-recommendation history for some stocks is short, the benefit from estimating JatTe
(1974) - Mandelker (1974) standard errors is small or non-existent.
 E. Devon and P. Marsh, EIXW studies and the see effect 125

The following statistic is used to determine whether the observed perfor-

mance is significantly different from zero:

Z *I = 0,*//m. (12)

We assume the performance measures represent drawings from a stationary

normal distribution. The z,, statistic is therefore Student-r distributed with
t - s degrees of freedom.

4. Results
Table 1 summarises the performance of recommended stocks evaluated
using all eight methodologies described in section 3.2. The monthly pre- and
post-recommendation performance figures are listed in the appendix, while
post-publication performance is plotted in fig. 1 below.
We begin by discussing the prior year and tip month performance (sections
4.1 and 4.2). Since our qualitative conclusions here are insensitive to the choice
of methodology, we focus, for ease of exposition, on the first two methodolo-
gies, namely simple market adjustment [eq. (2)] and the CAPM [eq. (3)] using
the capitalisation weighted FTA. We defer our discussion of the differences
between methodologies to section 4.3, when we evaluate post-publication
performance.

4.1. Pre-recommendation performance

The first column of table 1 summarises the performance of our sample over
the period from one year before the recommendation month until the tip date.
Over this period, recommended stocks outperform the market, as proxied by
the FTA Index, by 15 percent (see row 1). The equivalent CAPM abnormal
return (see row 2) is very similar, indicating that, as in many previous studies,
risk adjustment has only a small effect. A glance at the prior year figures for
alternative methodologies (rows 5 to 10) shows that, despite substantial
variation, all the abnormal returns are positive. The outperformance occurs
largely in the six months preceding recommendation (see the appendix).
Clearly, tipsters appear to favour stocks which have outperformed the market
in the recent past.

4.2. Performance in the tip month

Post-recommendation returns are calculated assuming purchase on the date
the journalist selects the stock. While this does not represent an investment
opportunity open to the public, it provides insight into journalists selection
skills. Journalists use some private as well as public information in formulat-
ing recommendations. This test is therefore in the spirit of published studies of
strong form market efficiency.

J.FE.- E
126 E. Damon and P. Marsh. Ecenr studies and the x1-e effect

Table 1
Abnormal performance of recommended stocks using alternative benchmarks and methods of
averaging.

Performance
Cumulative percentage returns (and t-statistics)
Row benchmark and Method of
IlO. equation number averaging Prior year Tip month One year Two years

1. FTA Index only (2) Equal 14.8 (7.0) 4.6 (10.1) 2.5 (1.4) 6.9 (2.2)
2. CAPM using FTA (3) Weighting 15.1 (7.2) 4.7 (10.5) 3.2 (1.8) 8.5 (2.8)
3. FTA Index only (2) Capitahsation - 1.2 (0.3) - 0.7 (0.8) - 2.1 (0.6) - 5.4 (0.9)
4. CAPM using FTA (3) Weighting - 0.1 (0.0) - 0.5 (0.6) - 1.7 (0.5) - 3.9 (0.7)
5. EW Index only (4) Equal 1.9 (3.5) 3.7 (7.7) - 5.6 (2.9) - 14.1 (4.0)
6. CAPM using EW (5) Weighting 3.5 (1.6) 3.3 (7.2) - 7.2 (3.8) - 18.9 (5.6)
7. Size control only (6) Equal 12.4 (7.4) 3.9 (10.8) -0.5 (0.4) - 1.3 (0.5)
8. Size and beta (7) Weighting 11.1 (6.5) 3.9 (10.6) -0.4 (0.3) - 1.3 (0.5)
9. SIMM using FTA (8) Equal 4.7 (2.4) 4.4 (7.7) - 2.6 (1.4) -4.8 (1.8)
10. SIMM using EW (9) Weighting 5.3 (3.1) 3.3 (6.8) - 3.2 (2.0) - 6.4 (2.8)

The prior year return is an average of 862 abnormal returns measured over the period from 12
months before the tip month to the date of the tip. The tip month return is an average of 792
abnormal returns on buy recommendations plus 70 abnormal returns from taking a short position
in stocks recommended for sale. measured from the date of the tip to the end of the tip month.
The one-year and two-year returns are also based on 792 long positions plus 70 short positions.
and are measured from the end of the tip month until 12 or 24 months later. The abbreviations
used here are as follows: FTA denotes the capitalisation weighted Financial Times-Actuaries All
Share Index; EW denotes the Dimson-Marsh (1985) Equally Weighted Index of all UK equities;
CAPM denotes the Capital Asset Pricing Model; SIMM denotes the Single Index Market Model.

The second column of table 1 shows that, between the recommendation date
and the end of the publication month, the tips achieve an abnormal return of
some 4 percent. Indeed, only three of the twelve sources of tips record perverse
performance. If financial journalists do not cheat (for example by withdraw-
ing a tip from publication after the selection date) and if deals are executed at
the middle market prices used in computing returns, then this could be
interpreted as a violation of market efficiency.
The magnitude of the abnormal performance is, however, relatively small,
and any potential short-term profits from following tipsters recommendations
would be more than consumed by UK transaction costs. Furthermore,

At the time of this study, most deals incurred round trip commissions of at least 1.5 to 2
percent, plus a 2 percent tax (stamp duty) on all purchases. In addition, the bid-ask spread is
estimated in work in progress by the authors to range from 1 percent for larger stocks to 10
percent or more for very small, infrequently traded securities. These trading costs are higher than
those found for large US stocks by Phillips and Smith (1980). but are comparable with the figures
for smaller NYSE and AMEX stocks documented by Schultz (1983). Interestingly, the highest tip
month abnormal returns, even after adjusting for size, are recorded for the tipsters who tend to
recommend smaller companies. These are precisely the companies for which the bid-ask spread.
and hence transaction costs. are the greatest.
 E. Dmson and P. Marsh. Event studies and the sr:e effect 127

investors cannot expect to deal at the price quoted by the journalist. Jobbers
(floor traders) read the recommendations, and adjust prices before any post-
publication trading takes place. It is therefore possible that the subsequent
quotation represents a switch from an average of the bid-ask prices to an
effective ask-only price. If so, we expect to witness a swift reversal of the initial
abnormal returns once the impact of publication is abated. In fact, we observe
neutral performance in the month after publication, both relative to the FTA
and using alternative methodologies (see appendix). Thus the 4 percent
abnormal return in the tip month appears to be attributable to the journalists
selection skills.
Several days may elapse between selection by the journalist and publication.
During this period, the underlying information content may find its way into
market prices. This is best illustrated by the portfolio tips made by Mr.
Bearbull. This weekly magazine becomes available to the public on Friday.
The publishers take delivery from the printers the previous day, and the
recommendation (press) date is three days before this. A study of daily returns
over the seven days following recommendation reveals a 4.1 percent abnormal
return [see Dimson and Marsh (1984b)). Of this, one third is realised prior to
the publishers taking delivery, and almost two thirds before the journal is
distributed to the public.
Either tipsters tend to recommend stocks which are expected to experience a
swift flow of favourable information, or they acquire information which leaks
to the market. Alternatively, there may be investment opportunities for the
tipsters themselves, although the editors of the periodicals represented here
indicated that pre-publication dealing would constitute grounds for dismissal.
Whatever the explanation, it is clear that this short-term performance is not
available to the public. If investors follow tipsters advice, they must buy at the
post-publication price.

4.3. Post-publication performance

4.3.1. Performance relative to the FTA Index

The third column of table 1 shows that over the one-year period from the
end of the recommendation month, the mean abnormal return using either of
the FTA based methodologies is around 3 percent [2.5 percent with simple
market adjustments [eq. (2)] and 3.2 percent using the CAPM [eq. (3)]. This
rate of outperformance is maintained over the following twelve months, and
the two-year abnormal gain is 6.9 percent with simple market adjustments and
8.5 percent using the CAPM. The two-year outperformance is significant at the
5 percent level, and over this horizon, all but three publications achieved
positive abnormal returns.
 128 &. Dimson and P. Marsh. Event srudies and the xe effect

Percentage abnormal return

..

5 -

5 -

-10 -

-15 -

-~.I,,,
0 2 4 6 8 10 12 I4 16 18 W 22 24
Monlh alter recommendalion

Fig. 1. Cumulative performance of 862 stocks recommended during 1975-82, evaluated using
eight alternative benchmarks. The abbreviations used here are as follows: FTA denotes the
capitalisation weighted Financial Times-Actuaries All Share Index: EW denotes the
Dimson-Marsh (1985) Equally Weighted Index of all UK equities; CAPM denotes the Capital
Asset Pricing Model; SIMM denotes the Single Index Market Model.

It seems unlikely that British tipsters can predict such substantial abnormal
returns, with as much accuracy for months 13 to 24 as for months 1 to 12. In
addition, the pattern of month-by-month cumulative abnormal returns dis-
plays a persistent upward drift rather than sudden jumps (see fig. 1). These
observations would, if methodologically correct, represent a violation of
market efficiency. One possible explanation is that these results occur by
chance, and our significance estimates are misleading, For example, serial
dependencies in mean abnormal returns might cause us to underestimate their
variance, so that significance levels are overstated. This explanation may be
tested by restricting calculations to recommendations evaluated over non-over-
lapping periods. Over the post-publication year, the New Year tips are
cross-serially independent, except for a possible one-month overlap. The
initial, one-year and (for completeness) two-year abnormal gains of the
restricted sample are 5.9, 4.1 and 14.0 percent, respectively, and the r-statistics
are virtually unchanged (7.6, 1.3 and 2.5, respectively) in spite of the reduced
sample size. Hence this explanation is rejected. Similarly, there is no evidence
 E. Dimon and P. Marsh. Ecent smdies and Ihe size effect 129

that we overestimate significance through inappropriate distributional assump-

tions. The coefficient of kurtosis for the monthly performance [u,, in eq. (ll)]
is not significantly different from its value for the normal distribution.
Using a standard, widely-employed event study methodology, namely the
CAPM, recommended stocks significantly outperform the market, as proxied
by the broadly-based capitalisation weighted FTA. However, inappropriate
conclusions on market efficiency are quite possible in the presence of the size
effect (see section 3.1) and these results may be misleading because of our
choice of weighting scheme and index.

4.3.2. Method of weighting and performance relative to the E W Index

When small companies outperform their larger counterparts, randomly
selected equally weighted portfolios may be expected to outperform a capi-
talisation weighted index, since capitalisation weighting gives greater weight to
the worse performing securities. Since our sample has a lower weighting on
large companies than the PTA (see section 2.1 above), and given the marked
UK size effect over this period, this may explain our results. One solution is to
apply consistent weightings, and compare capitalisation weighted event secur-
ity returns with the similarly weighted market index. If event securities are
drawn randomly from the population of index stocks, the expected abnormal
return will then be zero. This approach also ensures that, when results are risk
adjusted, betas estimated relative to the capitalisation weighted index (FTA)
retain a portfolio interpretation.
This approach, however, is statistically inefficient, and no previous event
studies have sought to produce capitalisation weighted results [but see Blume
(1976)]. Since our concern, however, is with distortions from the size effect, it
is interesting to explore the impact of capitalisation weighting, not for statisti-
cal testing, but instead for illustrative purposes.
Rows 3 and 4 of table 1 therefore present the market and the CAPM
adjusted abnormal returns when event security returns are capitalisation
weighted. Capitalisation weighting has a dramatic effect on the pattern of
results. With equal weighting, recommended stocks outperform the market
both prior to the tip and throughout the subsequent two years. However,
capitalisation weighting transforms the apparently superior performance into
slight negative performance in most periods, with more noticeable (although
statistically insignificant) underperformance of 4 to 5 percent in the two-year
post-publication period. These results provide further evidence that the find-
ings on tipsters selection skills may be an artefact of the size effect.
However the results in rows 3 and 4 of table 1 are strongly influenced by the
returns for a few especially large companies. The ten largest recommendations
130 E. Dmson and P. Marsh, Ecenr studies and the sre effect

in our sample have over 8,000 times the weight of the ten smallest. Clearly,
giving capitalisation weighting to event security returns is statistically ineffi-
cient, in spite of its apparent consistency attractions. An obvious alternative.
which meets the same consistent weighting criterion, but provides greater
statistical efficiency, is to revert to equal weighting for event security returns
and re-evaluate results against an equally weighted index. Although previous
British research has employed the capitalisation weighted FTA as the best
available index, equally weighted indexes have frequently been employed in
American studies.
Rows 5 and 6 of table 1 present the abnormal returns computed using the
EW Index as the benchmark [eqs. (4) and (5)]. Betas as well as returns were
estimated using this index. The results reinforce the above conclusions:
recommended stocks significantly underperform the EW Index by over 14
percent over the two years after publication, and by 19 percent on a risk
adjusted basis. This dramatic downward shift when abnormal returns are
measured against the EW Index rather than the FTA is reflected in the results
for all twelve sources of tips, with nine of them now exhibiting inferior
performance. Far from displaying selection skills, the analysts now appear
perverse.
We thus have evidence of both statistically significant overperformance by
recommended stocks relative to the FTA, and statistically significant under-
performance relative to the EW Index. In both cases, the abnormal returns are
larger in absolute magnitude the longer the post-publication period examined
(see the appendix). As Ball (1978) points out, when trading strategies offer
apparent abnormal returns which increase steadily over time, it suggests a
deficiency in the model of expected returns. Our results suggest that the
CAPM is an inappropriate benchmark for this event study. This is true
whether the model uses estimated betas, or assumes betas of unity; an equally
or capitalisation weighted index; or equally or capitalisation weighted event
security returns.
The major misspecification is the failure of the benchmark to reflect the size
composition of the sample. While tipsters tend to recommend larger compa-
nies, the probability of a stock being tipped is much less than proportional to
its capitalisation (see section 2.1). Hence a capitalisation weighted index is just
as misleading as an equally weighted index. Similarly, capitalisation weighting
event security returns places even greater weight on larger stocks than the

Note that risk adjustment has a greater impact when using the EW Index than with the FTA.
This is due to the higher excess return on the EW Index over the sample period (43 percent over
the two-year post-publication period, compared with 22 percent for the FTA), coupled with the
fact that the mean beta of stocks against the EW Index is 1.16. This high mean beta reflects the
above average capitalisations of recommended stocks, and the positive correlation between size
and beta for UK securities [see Dimson and Marsh (1983)].
 E. Dmson and P. Mursh. Ewnr srudes and rhe see efecr 131

capitalisation weighted index, again leading to apparent underperformance.

To compute meaningful abnormal returns, we need to adjust for the size effect.

4.3.3. Performance on a si:e adjusted basis

Row 7 of table 1 presents the abnormal returns computed using the simple
size control portfolio approach. Over all periods, the switch to size adjustment
pulls the abnormal returns to an intermediate figure between that obtained
using the FTA (rows 1 and 2) and the EW Index (rows 5 and 6). The largest
changes occur for tipsters who tend to recommend smaller firms.
Our general conclusions on pre-recommendation and tip month perfor-
mance are relatively unaffected by size adjustment. The outperformance in the
pre-tip year remains substantial at 12 percent. Similarly, size adjustment
reduces the tip month abnormal return only slightly from 4.7 percent (CAPM
with FTA) to 3.9 percent, and this figure remains statistically significant at the
0.1 percent level. The size adjusted post-publication results, however, cast an
entirely new light on our earlier conclusions. Performance is virtually neutral,
disclosing evidence neither of longer-term forecasting skills nor perversity.
Over the one- and two-year post-publication periods, recommendations under-
perform similar sized companies by only 0.5 and 1.3 percent, respectively.
Neither figure is statistically significant. Row 8 of table 1 shows that these
abnormal returns remain virtually unchanged when we adjust for beta as well
as size [eq. (7)l.t
Therefore, when abnormal returns are measured on a size adjusted basis,
there is no evidence of market inefficiency. Furthermore, in spite of substantial
performance differences between publications, none achieve statistically sig-
nificant outperformance over the one- and two-year post-publication periods.
The cross-sectional dispersion of tipsters post-publication performance is thus
probably attributable to sampling variation. It would be inappropriate to
claim that an advisory column with a favourable record can confidently be
expected to repeat its success.

4.3.4. Comparison with the market model

The last two rows of table 1 show the CARS estimated from the SIMM
using either the FTA or EW Index [eqs. (8) and (9)]. The tip month abnormal

This similarity between the results in rows 7 and 8 could be because the risk adjustment
procedure is ineffective in eliminating the influence of the market from the size adjusted returns.
However, a regression of size and beta adjusted abnormal returns on the corresponding excess
returns on the market discloses no relationship between the two. In fact, risk adjustment adds
little to the size based procedure because the betas of recommended securities are representative of
the stocks capitalisation deciles [see Dimson and Marsh (1984b)]. It is possible that for other
studies, risk adjustment would play a larger role.
132 E. Dimson and P. Mursh, Ecent studies and the si:e effect

return of around 4 percent is close to the figures obtained with the other
methods. In a single month, the alpha contributes relatively little, so that the
SIMM results resemble the corresponding CAPM results based on the FTA
and EW Index (rows 2 and 6). Over longer periods, however, the alpha plays a
more important role, causing market model results to deviate from their
CAPM counterparts (see fig. 1). Longer-term SIlMM performance is largely
insensitive to the choice of index [as in Brown and Warner (1980)], and the
post-publication CAR is -3 percent over one year, and - 5 to -6 percent
over two years.
Since, on a size adjusted basis, post-publication performance is neutral, the
SIMM results seem somewhat surprising. The general expectation in using the
market model is that each sample will act as its own control, with the mean
alpha estimate encapsulating factors such as the size effect. On the other hand,
the SIMM two-year performance figures are statistically significant at the 10
percent (FTA Index) and 1 percent (EW Index) levels, whereas the corre-
sponding CAPM results (rows 2 and 6) are more extreme and more significant,
at the 1 and 0.1 percent levels. In this study, the market model avoids some of
the bias which aflIicts the CAPM-type methodologies, but the SIMM results
are not as neutral as those obtained with size adjustment.
By definition, the SIMM takes account of the samples sensitivity to a single
factor, the market return, while also incorporating an estimate of the mean
non-market return per period via the constant term, alpha. If there are other,
extra-market factors at work, such as the size effect, then the SIMM is
misspecified. The magnitude of any resulting bias depends on the stochastic
nature of the omitted variables (we focus here simply on the size effect). It also
depends on the stability of any omitted coefficient, or in this case, the samples
sensitivity to the size factor, as measured by the average size of the event
securities. At one extreme, if the size effect is constant, and the average
(relative) size of the event securities remains stable over time, then the
estimated SIMM alphas wilI purge abnormal returns of all size-related bias.
On the other hand, if the size effect is volatile and/or non-stationary, then the
mean alphas will vary over time. Unless event dates are spread evenly over a

As Brown and Warner (1980) point out, one would expect market model results to be
insensitive to the choice of index. However, as their empirical results attest, this may not hold true
for simple market adjustments or CAPM-type, beta adjusted methods. They examine a randomly
selected sample of events with equal weight given to each, and tind that a capitafisation weighted
index incorrectly rejects the null hypothesis a whopping 20.4 percent of the time. Controlling for
beta reduces the rejection rate to 14 percent, but the latter would have been much higher with a
larger sample size (their sample contains only 50 events) and an observation period with a greater
size effect (their events span 1944-71 when the size effect was relatively small). Brown and
Warners conclusion that an improper use of the value weighted index was shown to cause
considerable problems which have not been recognised in extant event studies is consistent with
our findings here.
 E. Drmon and P. Mush. Ecent studies and the st:e effect 133

very long sample period, this can lead to biased performance measures.
Similarly, bias may arise if the average size of the event securities changes
between the estimation and prediction periods.
Given that our sample differs from the indexes in terms of size composition,
our results may therefore reflect variability in the size effect. Certainly, the UK
size effect does exhibit considerable year-to-year variation. When proxied by
the difference between the annual returns on the EW and FTA Indexes, it
ranges from a low of -49 percent (in 1975) to a high of +42 percent (in 1977)
during the period spanned by this study. If the size effect is generally larger
during the estimation period than in the prediction period, this could explain
our results. While recommendations are spread roughly evenly across years,
problems could still arise from starting and ending effects. In fact, however.
the average monthly size effect during the five-year estimation period was 0.47
percent per month, while the corresponding figure during the two-year post-
publication period was 10 basis points larger at 0.57 percent per month. If
anything, this should cause tipsters to slightly outperform the SIMM
benchmark.
An alternative explanation is that the average sensitivities of our sample
securities to the size factor may vary systematically between the estimation
and prediction periods. l3 For example, if event securities experience positive
abnormal returns over the (pre-event) estimation period, the alphas will be
biased. At the same time, this would be accompanied by an increase in relative
size for the sample stocks, making them, on average, larger in the prediction
than in the estimation period. This would accentuate the upward bias in the
alphas, resulting in spurious negative abnormal returns over the post-event
period. If correct, this implies that the exclusion period is inappropriately
chosen. However, we verified that the results are insensitive to whether we
halve or double the length of the exclusion period. In this sense, our results
appear robust. The bias to which we refer is more subtle than a simple failure
to exclude the immediate pre-recommendation period in which event-related
abnormal returns occur.

*The bias arises because event date clustering causes the weights given to various calendar
periods to differ between the pre- and post-event periods. This problem would be exacerbated by a
US-type seasonal in the size effect, particularly if event dates cluster around the turn of the year.
As already noted, however, the UK size premium exhibits no such seasonal over our sample
period.
13This is analogous to the well-documented problems arising from systematic changes in beta
[e.g.. see Mandelker (1974)l. Indeed, the negative abnormal returns in our own studv could arise
from betas shifting over time in an even; related manner. For example, if tipsters tend to
recommend stocks which they feel are becoming relatively less risky, then betas in the estimation
period will overstate betas in the prediction period, leading to apparent underperformance against
the SIMM benchmark. Overestimation by 0.15 to 0.20 would be sufficient to explain away the
observed results. However, we can reject this explanation, since the mean post-publication beta is
in fact underestimated (by 0.05) during the estimation period.
134 E. Dmson und P. Marsh, Event rruf~es und the see efect

The SIMM cannot reveal whether an estimation period alpha arises from
size (or other) factors or from event related abnormal returns. However, by
assuming the validity of a factor based model of the return generating process,
we can investigate whether the sample securities exhibit abnormal returns after
accounting for this size effect. We therefore estimate the average size adjusted
returns of the event securities, using eq. (8), over six non-overlapping pre-
recommendation periods of one year. Over the pre-tip year, the abnormal
return is 12.4 percent, while over the five years of the estimation period, the
abnormal returns are always positive, and average 3.4 percent per year. By
contrast, for a randomly selected set of securities, the abnormal return over
these years averages zero.
This evidence suggests that the SIMM alpha estimates are biased due to an
abnormal return over and above the size effect during the estimation period.
This implies that the sample stocks will have grown larger in (relative) size by
the prediction period, thus further accentuating the upward bias. This pre-event
abnormal return may be a consequence of an inevitable form of selection or
survivorship bias arising from estimating the SIMM parameters for only those
stocks which have (by definition) survived to the event date. Alternatively, it
may indicate that tipsters tend to recommend stocks which have performed
well over a very long prior period.
Unfortunately, we can find no exclusion period, not even one of seven years
or more, which leaves us with unbiased alphas according to our size adjusted
criterion. Some authors have sought to avoid these selection bias problems
associated with pre-event data by estimating SIMM parameters from post-event
data [see Copeland and Mayers (1982)]. Unfortunately this future benchmark
technique precludes making timely statements about investment performance.
Since our most recent event dates are only three years old, it would be
necessary to wait until 1989 to make statements about their two-year perfor-
mance. Nor does the future benchmark technique circumvent problems
arising from variability in the size effect. The best we can do in the context of
the market model is therefore to report the results based on the one-year
exclusion period, while recognising that this figure is a downward biased
estimate.

This poses serious problems when choosing an exclusion period, Ball (1972) suggests succes-
sively omitting months until any abnormal returns appear to be contained entirely within the
exclusion period. However, if there is a size effect, and the sample has deviant size exposure, this
procedure may reach a local optimum, or never converge. Indeed, Ball (1972) had to exclude 158
months of data, and Marsh (1979) could find no exclusion period which met this criterion. Even if
the criterion is met, this may be because event related, abnormal returns counterbalance the size
effect; and when the exclusion period is long, there can be large differences between the mean
capitalisations of the event securities in the estimation and prediction periods. In both instances,
the alphas will be biased.
 E. Dmson and P. Marsh. Ecent studies and thesi:e effect 135

5. Discussion and conclusion

The most striking feature of our results, as shown graphically in fig. 1, is

their very obvious sensitivity to the design of the experiment. Overall perfor-
mance can appear significantly positive or negative, depending on the choice
of index and methodology. Unless tipsters are to be credited (or debited) with
a market wide phenomenon, the size effect, performance must be evaluated
using a methodology which adjusts for size. On this basis, tipsters exhibit no
evidence of stock selection skills.

5. I. The impact of the size effect on event studies

Unlike the Brown and Warner simulations (1980,1985), our research is

equivalent to only a single observation from the population of event studies.
Yet, to the extent that our results are representative of the impact of the size
effect, they have important implications for past and future empirical work.
They may go part way towards explaining some of the anomalies in the market
efficiency literature and to resolving other disagreements between empirical
researchers [see Jensen (1978,1983)]. They also raise a puzzle about why so
many event studies, which ignore the size effect, nevertheless conclude that the
market is efficient. To judge the efficacy of previous work, and to ensure that
future studies are appropriately designed, it is worth clarifying the cir-
cumstances which induce bias. The most serious problems will arise when (1)
the measurement interval is long, (2) the event securities differ systematically
in size or weighting from the index constituents, (3) the size effect is large
and/or volatile, and (4) CAPM-type methodologies are used.
Taking these considerations in turn, it is firstly clear that the magnitude of
any bias depends on the length of the measurement interval. Our benchmarks
define a normal rate of return; and the importance of this normal rate, and of
any misspecification, declines rapidly as the period length tends to zero. For
studies using daily data, and focussing only on the immediate post-event
period, bias from benchmark misspecification is likely to be small relative to
event related returns and noise. However, as the measurement interval is
extended, any bias will be steadily magnified and can soon become dominant.
Numerous event studies report longer-term performance, and often (e.g., in
studies of recommendations) this seems natural and appropriate. Such studies
are potentially susceptible to size related bias.
Second, when there is a size effect, problems can arise if event securities
differ in their size or weighting from the index constituents. In spite of this,
most event studies treat the choice of index as inconsequential. Capitalisation
weighted indexes, for example, are widely used in the literature - see all
previous UK studies, other studies of stock recommendations [e.g., Bjerring,
136 E. Demon and P. Marsh. Ecent studies and the si:e effect

Lakonishok and Vermaelen (1983)], and many other well-known event studies
[e.g.. Kaplan and Roll (1972), Gonedes, Dopuch and Penman (1976) and
seven of the fourteen studies in Jensens (1983) Symposium on the market for
corporate control]. Yet if stocks experience an event with a probability less
than proportional to their capitalisation, then when there is a size effect, a
capitalisation weighted index can always be expected to underperform an
equally weighted portfolio of event securities. However, we have yet to identify
any published study in which the probability of an event is at least propor-
tional to capitalisation.
Similarly, an equally weighted index will produce biased results if event
securities are larger or smaller than the typical index constituent. Again, this
appears to be the rule, not the exception. For example, stock recommendations
and acquisitions are more prevalent for large companies, while initial public
offerings and financial distress are typically experienced by small firms. In
addition, event securities may be non-random with respect to size because of
sample selection requirements (e.g. the availability of prior stock price histo-
ries or supplementary accounting data), pre-event abnormal returns (as with
stock splits or rights issues), and the partitioning criteria employed (e.g.,
acquirers versus acquirees, or large versus small changes in dividends or
earnings). Cross-sectional regressions of abnormal returns on size-related
company characteristics can also suffer from all of the problems posed by
partitioning [see Jain (1982)]. Clearly, size mismatching is a potential problem
in many event study settings.
Third, the severity of any bias will depend on the magnitude and volatility
of the size effect. Event studies carried out in countries and periods in which
the size effect is negligible will avoid these problems. This seems unlikely to be
the norm, however, given the considerable evidence that the worlds stock
markets are characterised by substantial small firm effects, which vary consid-
erably over time, ls Event studies spanning short periods, or in countries with
narrowly based stock markets, are likely to suffer most from bias (e.g.,
Holland and Switzerland, where the three largest companies represent over
half of the equity market value). In countries such as the USA, where the size
effect has a seasonal, analogous problems may arise, particularly when events
cluster around the turn of the year. Similarly, event studies may experience
problems from extra-market factors other than size, in markets such as South
Africa, Australia and Norway where gold, natural resources and oil companies
are heavily represented.

See, for example, Banz (1981) and Brown, Kleidon and Marsh (1983) for the USA; Dimson
and Marsh (1985) and Reinganum and Shapiro (1984) for the UK; Brown, Keim, Kleidon and
Marsh (1983) for Australia: Berges, McConnell and Schlarbaym (1982) for Canada; Van den
Bergh and Wessels (1983) for Holland; Wahlroos and Berglund (1983) for Finland; and Nakamura
and Terada (1984) and Kato and Schallheim (1985) for Japan.
 E. Dimon and P. Mush. Evenr studies and the xe effecr 137

Finally, of the benchmarks investigated here, the most serious problems

arise with CAPM-type methodologies. This is because bias in CAPM based
abnormal returns is proportional to the magnitude of the small-firm premium,
and our sample period coincides with a large size effect. While many previous
studies employ the CAPM [e.g., Ball (1972), Kaplan and Roll (1972), Mandelker
(1974) and Jaffee (1974)], others use the market model, partly on the grounds
that the alpha estimates encapsulate any size effect. Unfortunately, market
model results are still distorted if the mean alpha during the estimation period
is a biased predictor of the expected value in the post-event period. This can
happen because of exclusion period problems, variability and/or seasonality
in the size effect, or non-stationatity in event security sizes. Thus while the
market model performs better than the CAPM, in the presence of a volatile
size effect it will not necessarily be free of bias.
Problems posed by the size effect extend beyond event studies, and may
potentially afflict all studies of longer-term performance, such as mutual fund
evaluation and portfolio performance measurement in general. Of all the
factors which influence stock returns, size is especially important, partly
because of its strong and established relationship with ex post returns, but also
because a mismatch of capitalisations is commonplace. However, since the
inclusion of sufficient factors in our benchmark would enable us, ex post, to
explain away all abnormal returns, we have, in any event study, to take a view
on which factors are event related. In this study, we assume that tipsters
forecast stock-specific security returns, and that their outperformance against
the FTA is not derived from insights into the size effect. The alternative view
begs the question of why they generally recommend larger stocks: if tipsters
are to be credited with the outperformance of small stocks, we must ask why
they did so much worse than would be expected if they had merely picked
stocks with a pin.

5.2. Summary and conclusion

This paper evaluates UK press recommendations made over the period
1975-82. While the recommended stocks significantly overperform the. capi-
talisation weighted FTA, and under-perform the equally weighted EW Index,
this reflects the size effect and provides no information on tipsters selection
skills. When the size effect is taken into account, recommendations provide an
abnormal return of 4 percent (before transaction costs) between the selection
date and the end of the tip month. Thereafter, performance is neutral.
We conclude that performance measures can be seriously distorted when (1)
the measurement interval is long, (2) event securities differ in size or weighting
from the index constituents, and (3) the size effect is large and/or volatile. The
biases are likely to be greater with CAPM-type methodologies, although the
market model is not an automatic panacea. Clearly, considerable care is
138 E. Dmson and P. Marsh. Ecenr studies and the see q$ect

required in interpreting conventional, long term performance measures. The

danger is that abnormal returns may tell us more about the appropriateness of
the benchmark than about true, event related performance.
Under the conditions enumerated above, our evidence suggests that re-
searchers should avoid using all of the techniques described in Brown and
Warner (1980). Instead, they should estimate abnormal returns using a meth-
odology which explicitly controls for size.
Our research provides fresh insights into the impact of the size effect on
event studies, and demonstrates the importance of taking this pervasive
phenomenon into account. Two conclusions emerge, one methodological, the
other empirical. The methodological conclusion in that longer-term perfor-
mance measures which ignore the size effect may be of no value to researchers.
The empirical conclusion is that published UK stock recommendations may
be of no value to anyone.

Appendix

This appendix reports the average of the abnormal returns on the 862
recommended stocks. Up to the day of tip, the return is based on holding all
862 stocks. From the day of tip onwards, the return is based on holding the
792 stocks recommended for purchase plus a short position in the 70 stocks
recommended for sale. Columns (2) to (9) refer to the eight alternative
methods for computing abnormal returns, i.e., eqs. (2) to (9), respectively.

Table 2
Cumulative percentage returns for 862 tips during 1976-82, using eight performance
benchmarks.

FTA CAPM EW CAPM Size Size SIMM SIMM

End of Index using Index using control and using using
month only FTA only EW only beta FTA EW
(1) (2) (3) (4) (5) (6) (7) (8) (9)

- 13 0 0 0 0 0 0 0 0
-12 0.7 0.7 0.5 0.0 0.5 0.2 0.7 0.5
-11 3.0 2.9 3.4 2.0 3.1 2.4 3.5 3.5
-10 3.3 3.3 4.3 2.3 3.3 2.4 3.2 3.7
-9 3.0 3.1 2.6 0.5 2.3 1.4 3.0 3.2
-8 3.9 4.0 3.4 0.9 3.0 2.0 2.9 3.0
-7 4.0 4.1 2.3 -0.3 2.4 1.4 2.5 2.3
-6 2.9 3.2 - -0.1 - 2.9 1.0 0.1 2.0 1.7
- 5 4.3 4.7 1.0 - 2.2 2.6 1.7 1.9 1.8
- 4 5.7 5.9 2.9 -0.7 4.4 3.2 1.9 2.5
-3 7.4 7.6 2.7 - 1.0 5.5 4.3 1.9 1.8
-2 10.2 10.4 4.9 0.6 8.4 7.1 2.7 3.0
- 1 12.0 12.3 6.1 1.7 10.1 8.8 3.2 4.1
Dav of tio 14.8 15.1 7.9 3.5 12.4 11.1 4.7 5.3
 E. Dun.wn and P. Marsh. Ecenr studies and the rr:e effecr 139

Table 2 (continued)

FTA CAPM EW CAPM Size Size S1.M.M SIMM

End of Index using Index using control and using using
month only FTA only EW only beta FTA EW
(1) (2) (3) (4) (5) (6) (7) (8) (9)

Day of tip 0 0 0 0 0 0 0 0
0 4.6 4.7 3.1 3.3 3.9 3.9 4.4 3.3
0 0 0 0 0 0 0 0 0
1 0.2 0.3 -0.2 -0.3 0.0 0.0 -0.1 -0.2
2 -0.1 0.3 -0.9 - 1.3 -0.5 - 0.4 -0.5 -0.9
3 -0.1 0.5 -0.9 - 1.7 -0.6 -0.4 -0.8 -1.1
4 0.2 0.8 - 1.9 -2.7 -1.0 -0.9 - 0.9 - 1.6
5 0.4 0.9 - 2.3 -3.0 -1.1 - 0.9 - 1.2 - 1.7
6 1.0 1.4 - 2.0 -2.9 -0.7 -0.6 - 0.6 -0.8
7 1.0 1.7 - 2.1 -3.1 - 0.6 -0.5 - 1.1 -1.0
8 0.4 1.2 -3.1 -3.8 -1.1 -0.8 - 2.0 - 1.4
9 0.6 1.4 - 4.3 -4.8 -1.3 - 0.9 - 2.6 - 2.2
10 0.5 1.2 -4.6 -5.3 -1.1 -0.8 -3.3 - 2.8
11 1.8 2.5 -4.7 - 5.6 - 0.6 -0.4 -3.1 - 2.8
12 2.5 3.2 -5.6 - 7.2 -0.5 -0.4 - 2.6 - 3.2
13 3.1 4.0 -6.2 - 8.2 -0.6 -0.5 - 2.0 -3.2
14 2.5 3.4 - 7.9 - 10.3 - 1.7 - 1.7 - 2.8 -4.2
15 2.4 3.4 - 8.4 - 11.3 - 2.0 - 2.1 - 2.8 - 4.0
16 2.8 3.9 - 9.6 - 12.4 - 2.0 - 2.0 -3.3 -4.7
17 3.3 4.4 - 9.8 - 12.7 - 1.9 - 1.8 -3.6 - 4.8
18 3.9 5.2 - 10.3 - 13.1 - 1.6 - 1.4 -3.5 -4.7
19 3.3 4.7 -11.3 - 14.5 - 2.3 -2.2 -4.1 -4.8
20 3.5 4.9 - 11.7 - 14.9 -2.0 - 2.0 - 5.0 -5.2
21 4.2 5.5 - 12.6 - 15.9 -1.7 - 1.7 - 5.6 -6.0
22 4.8 6.2 - 12.2 - 15.8 - 1.1 -1.0 - 5.7 -5.7
23 5.0 6.4 - 14.0 - 17.8 - 1.8 -1.8 -6.1 -6.7
24 6.9 8.5 - 14.1 - 18.9 - 1.3 -1.3 -4.8 -6.4

The abbreviations used here are as follows: FTA denotes the capitalisation weighted Financial
Times-Actuaries All Share Index; EW denotes the Dimson-Marsh (1985) Equally Weighted
Index of all UK equities; CAPM denotes the Capital Asset Pricing Model; SIMM denotes the
Single Index Market Model.

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