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Factor Investing Explained – Everything You Need to Know

Selecting the stocks and bonds to invest in should never be a decision you make lightly – nor a decision you should make based on your gut feeling! Every penny you invest should follow a comprehensive plan and stay in line with your go-to strategy. 

Over the past few decades, quant investment management strategies have become increasingly popular due to their potential to maximize your gains, minimize risks, and diversify your portfolio. Among them is the factor investment strategy that could give you a significant competitive edge when appropriately applied. 

Take a look below to have factor investing explained and learn its major pros and cons. Overview of factor investing 

Factor investing is a unique investment strategy that allows you to select your securities based on pre-defined characteristics, or factors, that generally yield better returns. Originating from the Arbitrage Pricing Theory (APT), it requires vast quantifiable datasets and thorough statistical analysis to be applied correctly. 

With factor investing, you’ll skip over the traditional analysis of individual stocks and instead choose securities based on their shared factors that have historically outperformed the benchmark index. 

The main factors in factor investing 

As the name would imply, to perform factor investing, you need to look into specific factors that can impact the performance of a stock or bond. They can be divided into two main categories – macroeconomic and style factors. 

Macroeconomic factors 

Macroeconomic factors are a broader category that defines the risks and opportunities across different asset classes. The principal macroeconomic factors you’ll need to consider when designing your factor investing strategy are as follows.

Interest rates 

Changes in interest rates significantly impact consumer spending and the value of stocks and assets. Higher interest rates discourage businesses and individuals from taking out loans, for example, which could slow down a company’s expansion plans and, therefore, potentially reduce its stock value. Lower interest rates have the opposite effect, encouraging spending and borrowing and ultimately leading to the possibility of greater profits. 

The rate of inflation 

Similar to the changes in interest rates, the rate of inflation dictates how much consumers and businesses can afford to spend. With rising costs of goods and services, businesses have fewer opportunities for expansion and lose profits since consumers have a lower purchasing power. Consequently, the value of a company’s stocks and assets can change significantly. 

Company’s credit 

The credit rating tells you more about the default risks of lending to a company. Considering that different stocks and bonds carry different levels of default risks, you’ll want to invest in those that provide adequate compensation for higher default risk. Alternatively, you can go for those with lower exposure to risks but that offer lower potential returns. 

Economy 

A growing economy is always beneficial to investors as it improves the stock market performance. Consumers can increase their spending while companies can increase their profits. A shrinking economy, however, diminishes a company’s chances of increasing or even maintaining its profits, resulting in a significant drop in its stock value. 

Style factors 

Unlike macroeconomic factors that consider characteristics that impact assets across classes, style factors focus on the risks and returns associated with individual asset classes. Take a look at the main style factors you’ll need to consider. 

Size 

Size might be one of the most critical factors you should consider. As a general rule of thumb, investors prefer going for small companies with high potential growth. Historically, you’d receive higher earnings from such small-cap stocks than you would from big-cap stocks. While they’re more volatile, they could have excellent growth potential. 

Value

Value investing refers to going for stocks and assets with a lower price than their relative fundamental value. Most commonly, you’d assess the value of a stock based on the price-to-earnings ratio, free cash flow, the number of dividends, and price-to-book ratio. 

Volatility 

Although assets with higher volatility, such as some of the popular cryptocurrencies, can occasionally offer fantastic returns, it’s generally better to go for those with lower volatility. Historically, stocks with lower volatility tend to provide much better risk-adjusted returns. 

Quality 

When using factor investment strategies, you’ll need to carefully examine the quality of the company before investing in its stocks. You can expect a better yield from companies that show signs of excellent financial health, with low debt-to-value ratios and higher returns on assets and equity. 

Momentum 

Stock momentum refers to the likely future price trends. Stocks that have outperformed the benchmark index in the past tend to continue following this trend in the future. Those that have underperformed tend to continue offering poor returns going forward. Most commonly, you should the relative returns within the past three months and up to a year to develop a strong momentum factor strategy. 

Benefits of factor investing 

Factor investing offers unique benefits that many investors can enjoy: 

  • Simplifies analysis as you can focus on just a few crucial metrics; 
  • Reduces your vulnerability to extreme volatility; 
  • Allows you to develop a systematic approach to investing; 
  • Removes emotional decision-making; 
  • Minimizes risks by diversifying your investment approach. 

Although it can be highly beneficial, factor investing is a complicated strategy that’s not generally recommended to beginners. 

Final thoughts 

Factor investing is a tried and true approach that can help you minimize risks and maximize profits. It’s a long-term strategy that relies on quantitative data to provide you with unbiased facts and help you make informed decisions.

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