- Factor investing involves analyzing statistical similarities among investments to identify shared factors that can be utilized to improve portfolios.
- Factors that factor investing can focus on include investment opportunity size, value, quality, and volatility.
- Factor investing has the potential to enable investors to benefit from portfolio diversification.
When investors need to determine how to allocate their capital, they often opt for a systematic approach that empowers their decision-making process. Factor investing is an excellent example of such a method. By analyzing statistical similarities between their investments, investors can identify common factors that they can exploit. Factor investing is widely recognized as a robust investment strategy.
Read on to find out about factor investing.
What are Investment Factors?
Investment factors are identifiable and measurable attributes, such as share liquidity and gross domestic product growth, that can elucidate differences in stock returns. The concept originated in 1976 with Stephen A. Ross’ arbitrage pricing theory, which posited that multiple factors accounted for security returns.
Since then, a number of investment factors have been identified by scholars and investors.
Main Investing Risks
Factor investing aims to reduce risk, including market, liquidity, credit, reinvestment, inflation, concentration, and time horizon risks. The approach of factor investing is regarded as a means of mitigating potential risks by concentrating on consistent, broad, and well-established drivers of returns.
The Systematic Approach
Systematic investing centers on rigorous testing, data-driven analysis, and methodical portfolio construction to assess the potential of an investment opportunity. Skilled investors frequently employ this approach to achieve diverse portfolio outcomes.
What is Factor Investing?
Factor investing is a systematic strategy that involves the examination, selection, weighting, and periodic adjustment of investment portfolios. The focus is on stocks that have demonstrated, over time, the ability to enhance risk-adjusted returns.
Investors can identify factors by utilizing rules-based exchange-traded funds that follow customized indexes, or by using actively managed quantitative funds.
Economy-related factors include:
- Gross Domestic Product. Investors may consider multiple factors when making investment decisions, such as the state of the economy, including whether it is expanding or contracting, as well as consumer spending trends. Additionally, fluctuations in the prices of goods and services are also significant considerations for investors.
- Inflation. A growing inflationary economy can negatively impact fixed-income securities.
- Interest rates. When interest rates increase, the stock market typically experiences a decline.
- Unemployment. The unemployment rate can provide investors with valuable insight into the general economic landscape.
Asset-Related factors include:
- Size. Historical data indicates that portfolios consisting of small-cap stocks have typically yielded higher returns than portfolios containing only large-cap stocks.
- Value. A widely accepted belief is that value investing tends to yield positive results because stock performance typically aligns with earnings over an extended period.
- Quality. Investors typically view companies with stable earnings, low levels of debt, strong corporate governance, and consistent growth in assets as favorable investment opportunities.
- Volatility. Empirical studies have indicated that portfolios with low volatility have the potential to outperform the broader market.
Factor Investing Pros and Cons
As with any type of investment strategy, there are pros and cons for factor investing:
- The approach of following a stock’s positive traits can increase the potential for better returns.
- Investment volatility can be reduced through this approach.
- A greater degree of investment diversification tends to reduce the overall risk exposure.
- Investing practices are best guided by greater discipline and less emotion.
- Investors should avoid over-indexing on one or two factors, which can lead to concentration risk.
- Investment factor analyses can become overly complex.
Factor Investing and Diversification
Factor investing was developed not only to potentially generate above-market returns and manage risk, but also to improve portfolio diversification. Although no investment strategy is entirely risk-free, holding multiple assets that perform differently can help mitigate overall portfolio risk.
Wise investors prefer an investment mix that is not entirely reliant on the stock market. Yieldstreet, an online alternative investment platform, is an example of this approach as it concentrates on generating predictable secondary income streams through various asset classes such as art and commercial real estate.
The concept is to rethink wealth creation by enabling investors to generate income beyond the conventional public markets.
Alternative Investing and Portfolio Diversification
Alternative investments can serve as a useful means to achieve this objective. Conventional portfolio asset allocation typically involves a 60% allocation to public stocks and 40% to fixed income. However, a more diversified portfolio with a balanced split of 60/20/20 or 50/30/20, which includes alternative assets, can help reduce sensitivity to short-term market fluctuations.
“Alternative investments” is a term that encompasses real estate, private equity, venture capital, digital assets, precious metals, and collectibles, among other asset classes. Generally, these investments are less correlated to public equities and offer the potential for portfolio diversification. However, it is important to remember that, like traditional investments, alternative investments also carry a certain degree of risk.
In certain instances, the risk associated with alternative investments may surpass that of traditional investments. That is why historically, these asset classes were only available to a select group of affluent individuals and institutional investors who could afford high minimum investments, typically ranging from $500,000 to $1 million. These investors were better equipped to handle significant losses if their investments failed to meet expectations.
Despite the risks, Investment.org has made a variety of expertly selected alternative investment strategies accessible to all investors. The company provides assistance in leveraging opportunities in areas such as real estate, legal finance, art finance, and structured notes, among other distinctive alternative investments.
Factor investing is a systematic investment methodology that can be combined with other investment approaches and techniques. One such technique is adding alternative assets to an investment portfolio with low correlations to unpredictable markets.