The Science of Investing: How Factor Investing Can Help You Achieve Your Goals
As investors, we all want to make smart decisions with our money and achieve the best possible returns. But, as we all know, the stock market can be a volatile and unpredictable place. So, how do we navigate this volatility and still achieve our goals?
One approach is to understand and take advantage of the underlying factors that drive returns, also known as factor investing. Instead of trying to predict short-term market movements, which is often impossible, factor investing focuses on understanding and investing in the underlying factors that have been shown to drive returns over the long-term. These factors include things like the size of a company, the value of a company, and how profitable it is.
Let’s take the example of a company’s value. Value companies are those that are trading at a lower price relative to their earnings or assets. According to Nobel-prize winning research by Fama and French, value companies tend to outperform growth companies over the long-term. This is because value companies are often overlooked by investors, leading to undervaluation, and they tend to be more resilient during market downturns. By investing in value companies, we can take advantage of this trend and potentially achieve better returns.
Another factor to consider is the profitability of a company. According to research by Novy-Marx, profitable companies tend to outperform unprofitable companies over the long-term. This is because profitable companies are more likely to be financially healthy and able to weather market downturns. This would seem to make rational sense, but how many investors today allocate their capital irrationally, by investing in companies that are currently unprofitable, with no clear plans to ever actually become profitable! By investing in profitable companies, we can take advantage of this trend and potentially achieve better returns.
Factor investing saves investors from having to search for the needles in the haystack. Instead, it helps investors figure out where in the haystack the needles tend to be found and it allows them to focus on the underlying factors that have been shown to drive returns over the long-term. It is a way to navigate the volatility of the market and achieve better returns in a more informed and strategic way.
Sources:
- “The Cross-Section of Expected Stock Returns” by Eugene Fama and Kenneth French, 1992. This is a seminal paper that introduces the concept of the Fama-French three-factor model, which includes size, value, and profitability as the factors that drive returns.
- “The Other Side of Value: The Gross Profitability Premium” by Robert Novy-Marx, 2013. This paper introduces the profitability factor as a significant driver of returns, and argues that profitable companies tend to outperform unprofitable companies over the long-term.
- “Factor Investing” by AQR Capital Management, LLC. This is a white paper that provides an overview of factor investing, including the historical evidence supporting the approach and the potential benefits for investors.
- “Dimensions of Investing” by Dimensional Fund Advisors, LLC. This is a white paper that provides an overview of the research behind factor investing, as well as the investment strategies and products offered by Dimensional Fund Advisors.
As investors, we all want to make smart decisions with our money and achieve the best possible returns. But, as we all know, the stock market can be a volatile and unpredictable place. So, how do we navigate this volatility and still achieve our goals?
One approach is to understand and take advantage of the underlying factors that drive returns, also known as factor investing. Instead of trying to predict short-term market movements, which is often impossible, factor investing focuses on understanding and investing in the underlying factors that have been shown to drive returns over the long-term. These factors include things like the size of a company, the value of a company, and how profitable it is.
Let’s take the example of a company’s value. Value companies are those that are trading at a lower price relative to their earnings or assets. According to Nobel-prize winning research by Fama and French, value companies tend to outperform growth companies over the long-term. This is because value companies are often overlooked by investors, leading to undervaluation, and they tend to be more resilient during market downturns. By investing in value companies, we can take advantage of this trend and potentially achieve better returns.
Another factor to consider is the profitability of a company. According to research by Novy-Marx, profitable companies tend to outperform unprofitable companies over the long-term. This is because profitable companies are more likely to be financially healthy and able to weather market downturns. This would seem to make rational sense, but how many investors today allocate their capital irrationally, by investing in companies that are currently unprofitable, with no clear plans to ever actually become profitable! By investing in profitable companies, we can take advantage of this trend and potentially achieve better returns.
Factor investing saves investors from having to search for the needles in the haystack. Instead, it helps investors figure out where in the haystack the needles tend to be found and it allows them to focus on the underlying factors that have been shown to drive returns over the long-term. It is a way to navigate the volatility of the market and achieve better returns in a more informed and strategic way.
Sources:
- “The Cross-Section of Expected Stock Returns” by Eugene Fama and Kenneth French, 1992. This is a seminal paper that introduces the concept of the Fama-French three-factor model, which includes size, value, and profitability as the factors that drive returns.
- “The Other Side of Value: The Gross Profitability Premium” by Robert Novy-Marx, 2013. This paper introduces the profitability factor as a significant driver of returns, and argues that profitable companies tend to outperform unprofitable companies over the long-term.
- “Factor Investing” by AQR Capital Management, LLC. This is a white paper that provides an overview of factor investing, including the historical evidence supporting the approach and the potential benefits for investors.
- “Dimensions of Investing” by Dimensional Fund Advisors, LLC. This is a white paper that provides an overview of the research behind factor investing, as well as the investment strategies and products offered by Dimensional Fund Advisors.