Factor investing is an investment strategy that lets you choose assets based on a specific set of factors or characteristics. Most investors don’t know it, but they do factor investing. Currently, you may be doing it accidentally. The purpose of this article is to explain factor investing so you can do it consciously. The characteristics that are part of factor investing lets you select a stock that increases chances of high returns.
There are two types of factors related to factor investing:
- Style Factor
- Macroeconomic factor
For retail investors, style factors are more relevant, and hence we will focus on these in this article.
Five style factors under factor investing are:
Value Factor – Most investors consider the value of a stock before buying stocks. You might always be looking for underpriced stock using fundamental analysis, right? Some factors that investors consider are the PE ratio, the dividend amount, and the cash flow.
Size – When you are doing factor investing, you look at the company size before investing. Under this, investors mostly prefer small companies with high growth potential. Historically, small-cap has provided higher earning than large-caps. However, be careful – not all small-cap give returns.
Quality – Under factor investing, investors will check the financial health of the company before buying it. They will look for factors like debt to equity ratios, return on assets, and return of equity. Unless stock ticks all the boxes, investors won’t buy it.
Momentum – Before picking stock for high returns, investors will also be checking the stock momentum. It means checking how stocks with positive returns are likely to perform in the future. In momentum investment strategy, you look at the returns for the last three to twelve months.
Volatility – Volatility is one of the essential parameters in factor investing. There are some stocks with high volatility in the market. Investors usually avoid such stocks in factor investing. Historically studies have shown that stocks with lower fluctuation outperform stocks with higher volatility.
Why invest using Factor Investing?
You reduce your portfolio risk as factor investing provides you diversification. Factor investing gives you high returns because the strategy follows a stock’s traits that have historically generated positive earnings with lower risk.
A word of caution
Sometimes an investors may accidentally expose themselves to additional risk instead of reducing their risk. For example, an investor using the size factor strategy may invest in small-cap stocks and eventually allocate a high percent in a small-cap which is not good. Also, if you don’t use all the strategies, you may end up increasing the risk.
We hope now you will be able to create a better portfolio for yourself. If you still have doubts, download our app, and we will do it for you.