Factor Investing For Dummies
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Factor investing is an investment portfolio general strategy that favors a systematic approach using factors or “shared characteristics” of individual stocks (and other assets, such as bonds) that have a historical record of superior risk and return performance.

These factors can range from individual characteristics, such as the company’s sales (revenue indicated on the company’s income statement) or debt (total liabilities indicated on their balance sheet), to their performance in macro environments, such as inflation or economic growth.

A factor is a trait or characteristic that can explain the performance of a given group of stocks during various market conditions.

There are two main categories of factors: style factors and macroeconomic factors.

Style factors

Style factors take into account characteristics of the individual asset, such as its market size, value and industry/sector, volatility, and growth versus value stocks. Style factors help to explain or identify characteristics that drive that asset’s price performance in the marketplace.

These factors are also referred to as microeconomic because they are an individual security or asset that drives its performance as a singular member or participant of the overall market and economy. Style factors include value, size, quality, dividend, growth, volatility, and momentum. We'll go over a few of these here:

Value factors

Looking at value means typically looking at the company’s fundamentals. The fundamentals are the most important financial data of the company, like the company’s sales and net profits, balance sheet (assets and liabilities), and important ratios, like the price-earnings (P/E) ratio.

Looking at public companies (as through their common stock) through the lens of value factors is one of the most important factors because value investing has survived and thrived ever since they were initially codified by the work of Benjamin Graham during the Great Depression years.

One of the most important reasons to embrace value as a primary factor (especially for beginning investors) is the emphasis on stocks that are undervalued, which makes them safer than other stocks.

Undervalued means that all the key fundamental financial aspects of the company (like book value or the price-earnings ratio) generally indicate that the price of the stock is not overpriced, meaning that you will not pay an excessive stock price versus the value of the underlying company and its intrinsic worth. The reason becomes obvious in market data; overpriced stocks are more apt to decline more sharply in a correction or bear market versus reasonably priced stocks.

The bottom line is the fundamentals of a stock mean a safer bet and a better chance at long-term price appreciation.

Size factor

The size of the asset, in this case, public company, is a reference to its market size based on market cap or capitalization (total number of shares outstanding times the price per share). The most common cap sizes used are small cap and large cap. If you’re seeking growth, lean toward the small-cap factor.

Large-cap assets may be safer but typically don’t exhibit the same growth or price appreciation relative to the small-cap stocks. The historical data generally bears this out.

Growth factor

The growth factor highlights the measure of change in sales and earnings by the company in relation to its group (like in individual industries or sectors). Is the stock growing better than its peers? If so, this factor should be considered.

As the historical market data suggests, companies with growing sales and revenue show stronger relative stock price appreciation, since investors notice the growth and buy up the stock.

Volatility factor

Market research over an extended period of time suggests that low-volatility stocks tend to earn a better return over the long term compared to high-volatility stocks. Given that, this factor will be beneficial.

A useful indicator to look at is beta, which is listed at many popular financial websites for a given stock. The beta indicates how much more (or less) a given stock is volatile versus the general market (based on recent market trading data).

For beta, the stock market itself is assigned a value of 1. A stock with a beta that is less than 1 is less volatile than the general stock market, while a stock with a beta greater than 1 is more volatile than the general stock market.

A stock with a beta of 1.2, for example, is considered 20 percent more volatile than the general stock market. A stock with a beta of, say, .9 is 10 percent less volatile than the general stock market.

A good example of a stock that has low volatility would be a large-cap public utilities company. A good example of a high-volatility stock would be a small-cap technology firm. If you’re a retiree, you would most likely benefit from this factor to ensure getting low-volatility stocks.

Macroeconomic factors

You could compare stocks and the stock market/economy to fish in a pond. You can analyze the fish and choose great fish (using, for example, style/microeconomic factors). But you should also analyze the pond (macroeconomic factors). You could choose the greatest fish in the pond, but what if the pond is polluted? Then even the great fish will underperform (putting it mildly). Shrewd investors will find a different pond.

For investors, the U.S. economy and stock market represent the “biggest pond” on the global financial scene. So if you’re going to participate, you should understand the good, the bad, and ugly of this marketplace.

Economic growth factor

Gross domestic product (GDP) is one of the most watched economic indicators by investors and non-investors alike. It’s a broad measure of the economic output (value of products and services) in a given timeframe (typically a calendar quarter or year) by a nation’s economy.

When GDP is growing, companies (and their stocks) are doing well. In fact, when the economy is growing and doing well, the stock market tends to outperform other markets (such as the bond market). Factors tied to economy growth such as GDP offer profitable guidance for investors.

Given that, the major investing sites regularly report this and related economic data so that this factor helps investors optimize the returns in their portfolio.

Inflation factor

Inflation is a key factor. Most folks look at price inflation (the rising price of consumer goods and services). However, price inflation is not a problem. It’s a symptom. Many people don’t understand the cause of inflation (including many government officials and economic policy makers unfortunately).

The cause is monetary inflation (the overproduction of a nation’s currency supply) that precedes the price inflation. When too much money is created and when that supply of money is chasing a finite basket of goods and services, then the price of these goods and services will rise. The goods and services didn’t become more valuable the currency lost value (due to overproduction).

A complicating factor is the supply shortage issues during late 2021 to 2022 that augurs in cost-push inflation. When shortages occur (supply issues) and consumers contain to purchase the products in question (demand), the price inflation is further exacerbated.

In early 2021, when the federal government and the Federal Reserve were increasing the money supply (by spending trillions of dollars), this was the cue for alert investors to consider the inflation factor. This factor would have guided portfolio managers toward securities that would have outperformed in an unfolding inflationary environment.

Interest rates factor

In early 2022, the Federal Reserve (America’s central bank) is (and likely will be) raising interest rates. Interest rates are essentially the price of borrowed money, and a factor on interest rates is key to making more optimal choices in your portfolio.

In general (and all things being equal), low interest rates are good for the economy while high (or rising) interest rates tend to be negative. Because so much economic activity (both business and consumer activity) is tied to credit (business loans, credit cards, home mortgages, and so on), rising interest rates tend to dampen or diminish economic activity while low or decreasing rates tend to do the opposite.

Given that, factors tied to interest rates can help you avoid stocks (and bonds) that would be harmed by rising interest rates so that your portfolio can continue to perform satisfactorily.

About This Article

This article is from the book:

About the book authors:

James Maendel, BFA, AAMS, AIF, DACFP, founded Maendel Wealth, an investment advisory firm. He has won the Five Star Wealth Management award for multiple years. Paul Mladjenovic is a national speaker, educator, author of Stock Investing For Dummies, Currency Trading For Dummies and other Dummies titles and runs RavingCapitalist.com.

James Maendel, BFA, AAMS, AIF, DACFP, founded Maendel Wealth, an investment advisory firm. He has won the Five Star Wealth Management award for multiple years. Paul Mladjenovic is a national speaker, educator, author of Stock Investing For Dummies, Currency Trading For Dummies and other Dummies titles and runs RavingCapitalist.com.

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