Understanding factor investing

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The core idea behind factor investing is explaining market returns that aren’t fully accounted for by beta as defined by the capital asset pricing model. Beta is a measure of a stock price’s volatility in relation to the overall market. If a stock has a beta measure of 2.0, that means that for every percentage point the overall market moves, the stock price moves two percentage points.

However, researchers have found that beta cannot explain total market performance. Theoretically, stocks with a high beta should outperform over time since the stock market tends to go up over the long term. In fact, a study by Robert A. Haugen and A. James Heins in the 1970s found stocks that are less volatile (i.e., those with a lower beta) outperformed more volatile stocks in the long run.

Other factors have since been uncovered by researchers, including value, size, momentum, and quality. Filtering stock selection with these characteristics can help investors put together a portfolio that produces superior risk-adjusted returns compared to simple passive investing strategies.

Monitoring the overall factors present in an existing portfolio can also ensure investors remain properly diversified within asset classes. It’s one thing to diversify across asset classes — think stocks versus bonds. It’s another to diversify within the asset class — think a mix of small-cap and large-cap stocks. Diversification across factors has shown to reduce portfolio volatility more than asset class diversification.

Ultimately, implementing a good factor investing strategy will allow investors to reduce risk and enhance returns.

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