The Three-Factor Model was introduced by Eugene Fama and Ken French in 1991. You might remember Fama from Part 1, he is also responsible for the Efficient Market Hypothesis back in the 1960s. The Three-Factor Model is a sort of subset theory to Modern Portfolio Theory, it takes things a step further. In Modern Portfolio Theory (Part 2) we see that strategic diversification is important for successful investing, The Three-Factor Model deals with the ‘strategic’ part of diversification. This research is very important for constructing portfolios. It means that you don’t want to simply owns lots of different asset classes, you want to own the right amount of the right asset classes to increase returns at minimal risk (volatility). As you might have guessed, there are three factors:
- Stocks outperform bonds (market effect). We want to be in the stock market. Bonds are good as you get closer to retiring because they’re not as volatile, but stocks will give the long-term returns that will allow for you to retire in the first place.
- Small companies outperform large companies (size effect). Large companies are the popular investment. We hear about the S&P 500, Dow Jones, and Nasdaq in the news almost exclusively; they’re all measurements of the largest US companies. Large companies are cheap to own, easy to trade, and you’ve heard of many of them, they make for a very popular investment. But over time, small companies will give you better returns. An ideal portfolio will not only include small companies, but it will also lean towards them.
- Value companies outperform growth companies (value effect). ‘Value’ means that the stock of a company is valued more closely to the actual worth of its assets. The stocks don’t have a built-in premium for growth potential because the companies aren’t expected to grow much. The stock prices of growth companies are much higher than the actual value of the company’s assets because of their potential, their expected growth. They’re also more popular than value companies, examples include Apple and Amazon and Google. Over time, value companies will give a better return than growth companies. Again, an ideal portfolio will not only include value companies, but it will also lean towards them.
The point of all this research is to help construct a better portfolio. Investing is not a shot in the dark or a gut feeling. It’s not even an educated guess about which asset classes or companies will make a jump next year. Investing is an academic exercise. We put these pieces of research together to model a portfolio that will put investors in the best position to capture market returns next year, and the year after, and every year moving forward. There are no pretensions that we know what will happen next year, we simply stay disciplined and diversified, we follow the rules, and we let the market do its work.