small cap stock beta

Tonight, as I was giving the 'night time' bottle to our 15-month old, I finally figured out something I've been pondering off and on for a while. I wondered, why would a disciple of Modern Portfolio Theory (MPT) expect small cap stocks to provide out-sized returns solely because they are more risky? Actually, I really wondered why they would perceive small caps as more risky?

Having been exposed to arbitrage pricing methods enough to be dangerous, I thought perhaps a collection of small cap stocks should be equivalent to one large cap stock. Or vice versa, one large company is perhaps equivalent to a collection of small companies. But then I remembered the math related to beta calculations and how say 10 small cap stocks, each with betas around 2.0, if put together would create a portfolio that still has a beta of 2.0. The reason is because the beta statistic itself already accounts for the cancelling out of individual stock idiosyncrasies, thereby providing a measure of a stock's underlying covariance with the overall market, net of any 'noise'.

So then I thought, of course that's why MPT followers would expect small caps to provide out-performance (because of greater risk as measured by beta). But I wondered, what is it about being small that makes small companies qualitatively more volatile? It can't be they are too small to have diversified revenue streams, otherwise as implied above, this volatility would go away when many small caps are held together in one portfolio. Rather, it must be something to do with each individual revenue stream (i.e. business) itself being volatile/risky.

But then, why would small companies be predisposed to having volatile revenues? I thinks it's simply by default. In other words, if a company finds a stable revenue stream, they tend not to stay small for very long. Because once you find a stable revenue stream, you no longer have to be quite so nimble to survive, and you can begin to pursue efficiency at the expense of flexibility. You start hiring some MBAs to standardize processes, acquire competitors to transfer best practices, badda bing badda bang, you get BIG.