The internet has a lot to say about Factor-Based Investing. In fact, a search for Factor Based Investing can bring up so many results with seemingly conflicting information that many people feel overwhelmed by it.
Factor Based Investing is an investing strategy in which you tilt your portfolio more heavily towards companies with certain characteristics, called “Factors.” There are a lot of possible Factors, but only a few work well enough for normal investors, like you, to make a profit.
Let’s break this down and make it easy.
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Why is Factor-Based Investing Important?
Investors are constantly looking for a way to “beat the market.” Unfortunately, many end up choosing to invest in tools that have the potential for big gains, but carry with them an imbalanced level of risk.
Despite their efforts to beat the market, the average investor picking and choosing their own investments ends up getting about 40% lower return than the market.
Factor-Based Investing offers an opportunity to beat the market while still balancing risk adequately.
How does it work?
Factor Based Investing seeks to increase the returns an investor makes while increasing risk the least amount possible. Balancing these two, risk and returns, creates what’s called “The Efficient Frontier” in Modern Portfolio Theory. Unfortunately, most people don’t know how to create an efficient portfolio on their own, which is why they end up losing money.
Something important to note here is that Factor Based Investing could increase the volatility in your portfolio. Thus, it’s important to work with a financial advisor to help craft a portfolio that will suit your needs.
What are the Factors?
As we mentioned before, companies report a lot of information, so it might seem that there are lots of different types of Factors. But in fact, only a few end up being profitable after fees, and are pervasive enough to apply to any market. Here they are:
Market – Compared to the “risk free rate” of investing in bonds, over time the stock market brings higher returns.
Size – Companies that are smaller tend to be more volatile, but end up offering more opportunities for profit.
Value – Companies that have a low Price-to-Book value have a better return than those with a high Price-to-Book value (sometimes called Growth stocks).
Quality – Companies with low debt and consistent earnings end up having a better returns than those with high debt and inconsistent earnings.
Momentum – Companies that have recently outperformed expectations tend to continue outperforming. This one is hard to capture because there is an element of randomness to it (When will it stop outperforming? Could be next month, next quarter, or next year, so when do you sell?). Plus, it has a high turnover rate, which ends up cutting into profits by incurring high trading fees.
Not only can these five factors bring returns, but they can also be used together, too, for even bigger rewards! However, as mentioned before, these returns come at the expense of increased risk.
What should you do next?
Before investing all your money in these factors, it’s important to create an investment plan to account for the years when these factors will get lower returns, or losses.
A financial advisor will be able to help you identify your specific risk tolerance, so you don’t overextend your portfolio.
If you’re ready to supercharge your portfolio with Factor Based Investing, click here to sign up for a FREE Bronze Account. One of our advisors will be in touch to help you get started!