What Is Factor Investing?
Factor investing is astrategythatchooses securities on attributes that are associated with higher returns. There are two main types of factors that have driven returns of stocks, bonds, and other factors: macroeconomic factors and style factors. The former captures broad risks across asset classes while the latter aims to explain returns and risks within asset classes.
Some common macroeconomic factors include: the rate of inflation; GDP growth; and the unemployment rate. Microeconomic factors include: a company's credit; its share liquidity; and stock price volatility. Style factors encompass growth versus value stocks; market capitalization; and industry sector.
Key Takeaways
- Factor investing utilizes multiple factors, including macroeconomic as well as fundamental and statistical, to analyze and explain asset prices and build an investment strategy.
- Factors that have been identified by investors include: growth vs. value; market capitalization; credit rating; and stock price volatility - among several others.
- Smart beta is a common application of a factor investing strategy.
Understanding Factor Investing
Factor investing, from a theoretical standpoint, is designed to enhance diversification, generate above-market returns and manage risk.Portfolio diversification has long been a popular safety tactic, but the gains of diversification are lost if the chosen securitiesmove in lockstep with the broader market. For example, an investor may choose a mixture of stocks and bonds that all decline in value when certain market conditions arise. The good news is factor investing can offset potential risks bytargeting broad, persistent, and long recognized drivers of returns.
Since traditional portfolio allocations, like60% stocks and 40% bonds, are relatively easy to implement,factor investing can seem overwhelming given the number of factors to choose from.Rather than look at complex attributes, such as momentum, beginners to factor investing can focus on simpler elements, such as style (growth vs. value), size (large cap vs. small cap), and risk (beta). These attributes are readily available for most securities and are listed on popular stock research websites.
Foundations of Factor Investing
Value
Value aims to capture excess returns from stocks that have low prices relative to their fundamental value. This is commonly tracked by price to book, price to earnings, dividends, and free cash flow.
Size
Historically, portfolios consisting of small-cap stocks exhibitgreater returns than portfolios with just large-cap stocks. Investorscan capture size by looking at the market capitalization of a stock.
Momentum
Stocks that have outperformed in the past tend to exhibit strong returns going forward. A momentum strategy is grounded in relative returns from three monthsto a one-year time frame.
Quality
Qualityis defined by low debt, stable earnings, and consistent asset growth. Investors can identify quality stocks by using common financial metrics like a return to equity, debt to equity and earnings variability.
Volatility
Empirical research suggests that stocks with low volatility earn greater risk-adjusted returns than highly volatile assets. Measuring standard deviation from a one-to three-year time frame is a common method ofcapturing beta.
Example: The Fama-French 3-Factor Model
One widely used multi-factor model is the Fama and French three-factor model that expands on the capital asset pricing model (CAPM). Built by economists Eugene Fama and Kenneth French, the Fama and French model utilizes three factors: size of firms, book-to-market values, and excess return on the market. In the model's terminology, the three factors used are SMB (small minus big), HML (high minus low) and the portfolio's return less the risk free rate of return. SMB accounts for publiclytraded companies with small market caps that generate higher returns, while HML accounts for value stocks with high book-to-market ratios that generate higher returns in comparison to the market.
FAQs
Factor investing is the strategy of targeting securities with specific characteristics such as value, quality, momentum, size, and minimum volatility. Factors are persistent and well-documented characteristics that can help investors understand differences in expected return.
What factors should be considered when creating your investing strategy? ›
Your investment strategy depends on your personal circ*mstances, including your age, capital, risk tolerance, and goals. Investment strategies range from conservative to highly aggressive, and include value and growth investing. You should reevaluate your investment strategies as your personal situation changes.
What is the determining factor for investment? ›
A change in any other determinant of investment causes a shift of the curve. The other determinants of investment include expectations, the level of economic activity, the stock of capital, the capacity utilization rate, the cost of capital goods, other factor costs, technological change, and public policy.
What are the best factors for investing? ›
In general, these can be broadly categorized as: value, size, momentum, low volatility, dividend yield and quality1. Understanding how these factors influence portfolio performance enables investors to leverage potential benefits such as: Enhancing the risk/return profile of a portfolio.
What factor is most important for you while choosing an investment? ›
Additionally, making an investment decision requires taking into account a number of important factors, including your personal financial objectives, risk tolerance, and budgeting abilities. It's critical to make the right choices today because they could have a big impact on your financial future.
What is a factor strategy in investing? ›
Factor style investing, has become prominent in recent years as investors seek to enhance portfolio returns and diversification while keeping volatility low. Factor investing is the strategy of targeting securities with specific characteristics such as value, quality, momentum, size, and minimum volatility.
What factors should be considered when making an investment decision? ›
Before making a new investment decision, the financial health of the company should be assessed. Financial documents such as income statements, balance sheets, and cash flow statements must be thoroughly examined to understand the company's liquidity, profitability, and debt structure.
What is an important factor to consider in determining an investment choice? ›
Time to Goals
The time horizon that each of your goals operates in would dictate the boundaries of the investment strategy that you consider for each of them.
What are the four factors to consider when selecting an investment? ›
Factors to consider when making investment decisions
- Reason of investment. The first, and most important thing to consider is the reason for making an investment. ...
- Researching the market. ...
- Risk levels. ...
- Investment Tenure. ...
- Taxations. ...
- Liquidity. ...
- Volatility. ...
- The Company.
- Your Investment Horizon – Think of your investment time horizon. ...
- Your Risk Appetite – Assess your ability to withstand fluctuations or loss in the value of your investments. ...
- Investment Knowledge: Start your investment journey by learning basics of investing.
In this blog, we discuss 6 key factors to consider when investing in a company to determine if this will be a good decision for you.
- The company's management team. ...
- The company's financial situation. ...
- The company's competitors. ...
- The company's customers. ...
- The company's suppliers. ...
- The company's industry.
Most successful investors start with low-risk diversified portfolios and gradually learn by doing. As investors gain greater knowledge over time, they become better suited to taking a more active stance in their portfolios.
What are the three factors that affect how an investment will grow? ›
Key Takeaways
- An investment can be characterized by three factors: safety, income, and capital growth.
- Every investor has to select an appropriate mix of these three factors. ...
- The appropriate mix for you will change over time as your life circ*mstances and needs change.
Interest rates (the cost of borrowing) Economic growth (changes in demand) Confidence/expectations. Technological developments (productivity of capital)
What are the factor considered to adopt an investment strategy? ›
Adjusting your investment strategy requires careful consideration of various factors. Market conditions, risk tolerance, investment goals, diversification, time horizon, tax considerations, and professional advice all play a crucial role in making informed decisions.
Why are investment strategies important? ›
Investment strategies can help you make quick decisions about whether or not to purchase an asset for your portfolio, reducing decision fatigue and the fear that you've made the wrong choice.
What are 3 considerations when choosing an investment strategy? ›
The proper asset allocation for your situation may differ. In applying any one of the profiles to your individual situation, you also should consider your other assets, income, and investments (including home equity, savings accounts, and other retirement plans), as well as your needs, goals and aversion to risk.
What are the main considerations in evaluating your investment strategies? ›
Here are the top ten essential factors to consider while making investment decisions.
- Risk tolerance. Your risk tolerance is your ability to withstand financial losses. ...
- Investment time horizon. ...
- Investment objective. ...
- Asset allocation. ...
- Fundamentals of the investment. ...
- Market trends. ...
- Fees and charges. ...
- Tax implications.
Here are six steps to consider to help build a portfolio.
- Step 1: Establish Your Investment Profile. No two people are exactly alike. ...
- Step 2: Allocate Assets. ...
- Step 3: Decide how to diversify. ...
- Step 4: Select investments. ...
- Step 5: Consider Taxes. ...
- Step 6: Monitor your portfolio.
How to Build an Investment Portfolio in Six Steps
- Start with Your Goals and Time Horizon. ...
- Understand Your Risk Tolerance. ...
- Match Your Account Type with Your Goals. ...
- Select Investments. ...
- Create Your Asset Allocation and Diversify. ...
- Monitor, Rebalance and Adjust.
