By Nicholas Vardy Every investor is looking for an edge to beat the market.
Factor investing offers just that kind of edge.
It’s the investment “free lunch” that promises the holy grail of investing… beating the stock market with less risk.
So just what is a “factor”?
Factors explain why specific investment strategies outperform the market over time.
If you’ve heard the terms “value” or “momentum investing,” then you’ll already be familiar with two of the most important factors.
Today, I’ll give you a quick overview of the “big five” most persistent investment factors – value, momentum, quality, size and low volatility.
1. Value
The idea behind value is both familiar and straightforward: Cheaper stocks outperform more expensive stocks over the long run.
Expensive growth stocks rarely meet their lofty expectations. Conversely, cheaper value stocks tend to surprise on the upside.
Published in 1934 in the middle of the Great Depression, Columbia Business School professor Benjamin Graham’s Security Analysis is the bible of value investing.
Graham recommends that investors buy stocks at a discount to their intrinsic values.
Graham taught that you can calculate a stock’s intrinsic value by using measures like price-to-book (P/B) and price-to-earnings (P/E) ratios.
Research by Fidelity Investments shows that between 1985 and 2015, stocks with a low average P/B or P/E outperformed a broader market cap-weighted index by 2% and 3% per year, respectively.
2. Momentum
Momentum investing is based on the observation that once a stock starts to rise, it tends to keep going.
Put another way… “The trend is your friend.”
Academics and die-hard value investors cringe when they hear the word “momentum.” After all, the success of momentum investing is an insult to their hyper-rational approach.
But it’s no surprise to technical analysts. They know that investors tend to pile into a stock once it starts going up.
Momentum investing is less about abstract theory than real-world investor behavior. Unlike the perfectly rational “homo economicus” (economic man) you find only in finance textbooks, most investors are driven by FOMO – the fear of missing out.
Again, between 1985 and 2015, momentum stocks that outperformed over the prior 12 months beat a broader market cap-weighted index by an average of 1.5% per year.
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3. Quality
It seems like common sense: Invest in high-quality companies and you generate higher returns.
Not surprisingly, research has confirmed that stocks of high-quality companies beat the market over time.
A strong balance sheet, stable earnings, increasing dividends and reasonable leverage are all hallmarks of quality companies.
Most importantly, high-quality companies have “wide moats” – sustainable competitive advantages – that allow them to earn higher profits than their competitors.
Think of what it would take to launch a rival to Visa (NYSE: V) or The Coca-Cola Company (NYSE: KO) and you’ll understand the power of a wide moat.
Investing in a portfolio of quality companies between 1985 and 2015 outperformed the market cap-weighted index by an average of 1.6% per year.
4. Size
The “small cap effect” is the market anomaly that small cap stocks consistently outperform large cap stocks over the long run.
Eugene Fama, a 2013 Nobel Prize winner in economics, and his colleague Ken French found that small cap …read more
Source:: Investment You
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