I’ve recently described the problems with making market predictions and whether it takes luck or skill to beat the market. The next step is to describe the characteristics of the stock market, called “factors“, which help explain the gains and losses. There are dozens of factors that have been studied, but only a few provide enough gains, over the long-term, to justify the risk. Here is a short description of the most popular factors:
- Value–investments with low price to earnings or price to book ratios tend to outperform investments with high price to earnings or price to book ratios.
- Size–investments with lower capitalizations tend to outperform investments with higher capitalizations.
- Momentum–investments that have performed well over the past few months tend to outperform investments that have performed poorly over the past few months.
- Volatility–investments that are less volatile tend to outperform investments that are more volatile.
- Dividend Yield–investments that have a higher dividend yield tend to outperform investments that have a lower dividend yield.
- Quality–investments that have low debt, stable earnings and other measurements of “quality” tend to outperform investments with more debt and inconsistent earnings.
Each of these factors represent additional risks that investors take on by buying investments with those characteristics. For example, value stocks with low price to earnings ratios are thought of as riskier because something is often perceived to be wrong with the company, which explains the lower price to earnings ratio. There are many factors that have been studied and determined to have no effect or even a negative effect on returns. Further, the reward for each of the above factors is also widely debated and seems to change year-to-year. Finally, some of the factors do not logically equate to more risk, such as lower volatility investments outperforming higher volatility investments.
So how do you invest to take advantage of these factors, which vary from year to year in usefulness, are not guaranteed to work over any particular period of time, but in the aggregate have beaten the market? Here are three options:
- Ignore them. If you are diversified in index funds and rebalance your holdings annually, then you will likely have an average amount of exposure to these factors at a minimal cost.
- Invest in factor-based funds. Rather than trying to time or guess which factors will perform the best over your investment horizon, there are some low cost funds that give exposure to one or more of the above factors. You don’t have to go all-in with factor investing, but you could make sure to have some exposure to each of the factors through your selection of a diversified group of funds. You could even apply a momentum or return-based method to determine which factors are worth buying right now.
- “Factor the factors” in individual stock selection. If you want to hold individual selections then keep the above factors in mind as part of your security selection process.