August 08, 2022
Factor investing is one of those somewhat vague, catch-all terms that can easily leave you wondering what it even means if you don’t look carefully. Essentially though, what it boils down to is picking stocks based on certain factors and characteristics about the equity or the company that fit your criteria.
Whether it’s momentum stocks, low debt or high cash flow companies, volatile stocks, or just investments that tend to out move the market, (more volatile) factor investing can mean a lot of different things, and it depends mostly on your own portfolio preferences.
Diversifying and risks
Factor investing is one way to diversify your portfolio, but it’s not without its own risks. Factor investing involves using a number of different factors in order to diversify the risk of your portfolio, including the market factor, size factor, value factor and momentum factor.
- Systematic or market risk: This type of risk is associated with general economic and financial conditions such as inflation, interest rates, and equity markets.
- Unsystematic or company-specific risk: This type of risk is associated with individual companies in a portfolio such as their management strategies, competitive position in the market, and financial constraints.
- Idiosyncratic or individual security risks: This type of risk is associated with specific securities within a portfolio such as price fluctuations for a particular stock.
Factor investing in action
One of the most popular methods of introducing factor investing to your overall strategy is the Fama-French 3-Factor Model, which is an asset pricing model built back in 1992 to expand on the capital asset pricing model (CAPM).
The goal, ultimately, of this model is to attempt and derive true value from an investment, taking into consideration additional factors that other models do not.
The factors included are:
- Size: The market’s belief in the company.
- Value: How cheap the company is.
- Momentum: Whether the company has been doing well recently.
The model shows how to construct an efficient portfolio. The size factor captures the risk of holding a stock, while the value factor captures how cheaply you can buy it. Momentum captures how well it’s done recently – this is also called “reversion to the mean.”
Implementing factor investing in your own portfolio
The above example is just one of many ways to go about implementing factor investing, and it’s important we take the time to construct our own framework that caters to our own preferences before diving in.
Additionally, it’s also paramount to avoid tunnel vision while investing too, and not get too fixated on a single approach. Factor Investing can be a great addition to your portfolio and your overall repertoire, but diversification is always necessary and something to never lose sight.