The Investing Fab Five - Show 131

Wednesday, July 30, 2014 3,927 views

Here at IFA, we are constantly driving home the message of risk being the source of returns. Without risk, there is no return. And while risk seems pretty self explanatory, there are actually several different types, each carrying with them a different degree of risk. Nobel Prize Winner Eugene Fama and Professor Kenneth French created the Five Factor Model. This model identifies five factors that deliver returns to investors. On the Stock side of portfolios, Market, Size and Value determine as much as 96% of returns.

Market risk is the investor’s exposure to the overall stock market. Value risk refers to the amount of a portfolio’s holdings of low priced stocks relative to their book value. And finally, size risk is the level of a portfolio’s exposure to small company stocks.

So why break down each of these risks? It’s important because it allows you to see if it’s worth it to tilt a portfolio towards one thing or another. We can study history and see the annual historical return premiums based on these factors. Let’s look at the Market Risk factor. If you compare being in the market or being in treasury bills, the premium investors get is 7.93%. What about the value risk factor? When value stocks are juxtaposed against growth stocks, the returns premium is 4.99%. Finally, when comparing small companies and large companies, previously described as the size factor, the premium of investing in small companies has been 3.12% annually since 1928.

So what does this mean? First: The most important thing is to be IN the market and not sitting on the sideline in Treasury Bills. Next, there’s some definite premiums gained from being in small company stocks and value stocks. So a portfolio with a small-value tilt has historically shown to give you a higher expected return.

The research of Eugene Fama and Kenneth French serves as a guiding protocol for both individual and institutional investing. And their Five-Factor Model is the framework by which all IFA portfolios are built.

 

 

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