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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Systematically secure your financial future--Dummies makes it easy Factor Investing For Dummies helps you go beyond the investment basics, with proven techniques for making informed and sophisticated investment decisions. Using factor investing, you'll select stocks based on some predetermined, well, factors. Momentum, value, interest rates, economic growth, credit risk, liquidity--all these things can help you identify killer stocks and improve your returns. This book explains it all, and helps you implement a strategic factor investing plan, so you can boost your portfolio's performance, reduce volatility, and enhance diversification. You'll also learn what not to do, with coverage of the factors that have failed to deliver consistent returns over time. We explore factor-based ETFS and loads of other ideas for injecting some factors into your investment game. * Learn what factor investing is and how you can use it to level up your portfolio * Understand the various types of factors and how to use them to select winning stocks * Choose from a bunch of factor investing strategies, or build one of your own * Generate wealth in a more sophisticated, more effective way This is the perfect Dummies guide for beginner to seasoned investors who want to explore more consistent outperformance potential. Factor Investing For Dummies can also help portfolio managers, consultants, academics, and students who want to understand more about the science of factor investing.
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Veröffentlichungsjahr: 2022
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Factor Investing For Dummies®
Published by: John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, www.wiley.com
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Published simultaneously in Canada
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Library of Congress Control Number: 2022946843
ISBN 978-1-119-90674-2 (pbk); ISBN 978-1-119-90675-9 (ebk); ISBN 978-1-119-90676-6 (ebk)
Factor Investing For Dummies®
To view this book's Cheat Sheet, simply go to www.dummies.com and search for “Factor Investing For Dummies Cheat Sheet” in the Search box.
Table of Contents
Cover
Title Page
Copyright
Introduction
About This Book
Foolish Assumptions
Icons Used in This Book
Where to Go from Here
Part 1: Starting with Factor Investing Basics
Chapter 1: Counting on Factor Investing
The Essentials of Factor Investing
Introducing the Factor Groups
An Example of a Factor-Based Portfolio
The Upside and Downside of Factor Investing
Factor Investing through ETFs and Mutual Funds
Chapter 2: Why Use Factors?
Following a Systematic Approach
Considering Reasons to Use Factors
Using the Two Models of Factor Investing
Chapter 3: Knowing Which Factors Are Worth Your Time
Putting You in Charge of Your Factor Investing Strategy
Navigating the Factor Jungle
Avoiding the Factor Zoo
Chapter 4: Beating the Market without Timing It
Looking at the Indexes that Make Up the Market
Planning Your Market Strategy
Beating the Market with Factors
Part 2: Going Deep with Factor Strategies
Chapter 5: Making Room for the Growth Factor
Seeking Profitability
Looking for Stable Earnings
Staying Vigilant for Non-Quality Growth Stocks
Employing a Low Turnover Strategy
Chapter 6: Value Investing with Factors
Paying for Value
Analyzing the Fundamentals
Chapter 7: Banking on Momentum with Winners and Losers
Defining Momentum
Making Money by Short-Selling Downtrends
Knowing the Potential Limitations of the Momentum Factor
Choosing a Momentum Approach
Chapter 8: Sizing Up a Stock's Size
Defining the Size Factor
Exploring the Cons of the Size Factor
Using Size Factor with Funds
Chapter 9: Dividend Income Using Factors
Getting Started with Dividends
Understanding the Difference Between Dividend Amount and Dividend Yield
Knowing the Dividend Payout Ratio
Checking Dividend Growth
Getting Paid by Your Dividends
Reinvesting Your Dividends
Projecting Dividend Income
Part 3: Using Factor Investing in Your Portfolio
Chapter 10: Using Brokerage Orders with Factor Investing
Understanding the Types of Brokerage Orders
Using Margin
Chapter 11: Using Macro Factors
Exploring the Main Macro Factors
Checking Out Other Economic Indicators: Leading, Lagging, and Coincident
Watching Macro Factors and Trends
Chapter 12: Combining Multiple Factors for a Powerhouse Portfolio
Creating a Combination of the Right Factors
Taking an Optimal Approach with ETFs and Funds
Using the Optimal Approaches for Factor Investing
Taking Advantage of the Professionals
Chapter 13: Going Global with Factor Investing
Exploring Why You Should Invest Globally
Investing in Environment, Social, and Governance
Chapter 14: Performing Technical Analysis for Factor Investing
Tracking a Stock’s Relative Strength Index (RSI)
Checking a Stock’s Technical Charts
Adding Up Moving Averages
Chapter 15: Using Stock-Screening Tools in Your Factor Investing
Finding Investments with a Screening Tool
Using a Screening Tool to Find Factor Stocks
Finding ETFs with Screening Tools
Part 4: Applying More Complex Investment Tactics
Chapter 16: Outsourcing with ETFs and Mutual Funds
Comparing ETFs to Other Investments
Diving into the Broad Market of Exchange-Traded Products
Combining Sectors with Macro Factors
Exploring Factor Mutual Funds
Chapter 17: Bonds and Factor Investing
Defining Bonds
Using Factors with Bonds
Taking into Account the Key Issues with Bonds
Understanding the Elements of Bonds
Looking at Savings Bonds
Investing in Multifactor Bond Exchange-Traded Funds
Chapter 18: Using Options with Factor Investing
Writing Call Options
Selling the Put Options
Being Strategic with Your Options
Chapter 19: Watching the Factors that Lead to Major Market Moves
Tracking the Early Warning Signals
Navigating Volatile Periods
Investing in Commodities
Chapter 20: Considering Taxes
Understanding the Tax Treatment of Different Investments
Sharing with the IRS
Taking Advantage of Tax Deductions
Investing in a Retirement Account
Keeping Up on Tax Resources
Part 5: The Part of Tens
Chapter 21: Ten Do-It-Yourself Factors
Profit
Sales
Consistency
Debt
Price-Earning Ratios
Dividend Income
Human Need
Optionable
Industry Top 20%
Political and Economic
Chapter 22: Ten Ways to Mess Up Your Investment Plan
Breakevenitis
This Time It's Different
Cutting Winners Short and Letting Losers Stay
Letting Fear and Greed Lead
Buying the Hype
Using Leverage
Buying or Selling Everything at Once
Getting Impatient with Positions That Aren’t Working
Borrowing or Going into Debt to Invest
Micromanaging Your Portfolio
Chapter 23: Ten Non-Factor Strategies and Considerations
Pay Off Debt
Save an Emergency Fund
Plan for Taxes
Consider Insurance
Plan Your Estate
Watch the News
Monitor the Companies
Know How the Federal Reserve Works
Maintain Your Career
Practice Diversification
Chapter 24: Ten Financial Problems You Can Navigate with Factor Investing
Recessions
Subprime Lending Crisis
High Inflation
Market Crashes
Pandemics
Government Overreach
Hyperinflation
Tight Labor Market/Talent Shortage
Black Swan Events
Market Shutdowns
Part 6: Appendixes
Appendix A: Resources for Factor Investors
Factor Investing Books
Other Valuable Books for Factor Investors
Periodicals and Magazines
Resources on the Big Picture for Factor Investors
Investing Websites
Fee-Based Investment Sources
Exchange-Traded Funds
Sources for Analysis
Government Information
Appendix B:Factor-Based ETFs
Index
About the Authors
Advertisement Page
Connect with Dummies
End User License Agreement
List of Tables
Chapter 26
TABLE B-1 Alternatives: Absolute Returns
TABLE B-2 Asset Allocation: Global Target Outcome
TABLE B-3 Asset Allocation: U.S. Target Outcome
TABLE B-4 Commodities
TABLE B-5 Currency ETFs
TABLE B-6 International ETFs
TABLE B-7 Developed Markets Ex-US
TABLE B-8 Emerging Markets
TABLE B-9 Specialized Global Markets
TABLE B-10 U.S. Large-Cap Stocks
TABLE B-11 U.S. Small-Cap Stocks
TABLE B-12 U.S. Stocks – Total Market
TABLE B-13 Factor-based Sector ETFs
TABLE B-14 Bonds
TABLE B-15 Leveraged ETFs
List of Illustrations
Chapter 2
FIGURE 2-1: DALBAR.
FIGURE 2-2: Capital Asset Pricing Model.
Chapter 3
FIGURE 3-1: Factor strategies are relative newcomers but gaining popularity.
FIGURE 3-2: Survivorship bias: active versus delisted stock universe.
Chapter 4
FIGURE 4-1: How the S&P 500 has performed.
FIGURE 4-2: How World War II events affected the stock market.
FIGURE 4-3: Pros who beat the market.
FIGURE 4-4: Missing the best days.
Chapter 5
FIGURE 5-1: How quality growth factor companies perform.
FIGURE 5-2: Growth versus value since 1926.
FIGURE 5-3: Growth versus value since 1994.
Chapter 7
FIGURE 7-1: A snapshot comparison between a momentum EFT and a benchmark ETF.
FIGURE 7-2: How one ETF compares to another in 2021.
FIGURE 7-3: A short trade of an ETF.
FIGURE 7-4: The risk and rewards of selling short.
FIGURE 7-5: How momentum factor ETFs have fared.
Chapter 8
FIGURE 8-1: The small caps at their lowest valuations in 20 years.
FIGURE 8-2: The size factor in the economic cycle.
Chapter 11
FIGURE 11-1: GDP chart for the United States.
FIGURE 11-2: Historical inflation.
FIGURE 11-3: Shadow stats chart.
FIGURE 11-4: Interest rates history.
Chapter 12
FIGURE 12-1: A multifactor approach is a good long-term strategy.
FIGURE 12-2: Dollar cost averaging in action.
Chapter 13
FIGURE 13-1: 2030 forecast composition of global stock market by country.
FIGURE 13-2: The ten best performing markets.
FIGURE 13-3: ESG asset growth.
Chapter 14
FIGURE 14-1: A trend channel.
FIGURE 14-2: A head and shoulders pattern for a stock.
FIGURE 14-3: A reverse head and shoulders pattern for a stock.
Chapter 15
FIGURE 15-1: The Yahoo stock screener.
FIGURE 15-2: The ETF database screening tool.
FIGURE 15-3: An ETF comparison tool.
Chapter 16
FIGURE 16-1: The ETF factor home page.
Chapter 18
FIGURE 18-1: Stock chart for selling options.
Chapter 19
FIGURE 19-1: A commodities chart.
Chapter 24
FIGURE 24-1: Black Monday, 1987 crash chart.
FIGURE 24-2: The Zimbabwe 100 trillion dollar note.
Guide
Cover
Title Page
Copyright
Table of Contents
Begin Reading
Index
About the Authors
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Introduction
Factor investing has been flying under the radar for decades as professional money managers have successfully used them for better investment portfolio management and performance. But now anyone can find out about what they are and how they can successfully improve your investment success. Many financial planners, advisors, and portfolio managers have turned to factors so they’re not flying blind in volatile and uncertain markets. A factor-based approach has the power to level the playing field.
Factor Investing For Dummies helps you make sense of what has been a tested and proven approach that professional money managers have kept secret for nearly a half century and still popular and proven in today’s turbulent markets.
About This Book
Factor investing is generally new to the public and it can be so valuable to anyone managing an investment portfolio, especially stocks and stock-related funds. This book is laid out so you can go from learning what factors are to how to use them and which ones work best in varying economic conditions.
The early part of the book goes in the basics of factors and the different kinds there are. There are factors designed to do well in periods of economic growth and those that hold up well in bad times. Style (or microeconomic) factors are tied to the strength of the individual stocks (and their underling companies), while macro factors are tied to the general economic environment. Stocks and funds with macro factors have a a better chance of succeeding versus the general stock market.
The book doesn’t stop at just factors; it rounds out a more complete picture so you don’t miss a beat with your overall factor-based investing approach. You will find out that factor-based ETFs and mutual funds can be an easy way to incorporate factors in your investment picture. Need income? See how factors can help you generate dividend income or use call and put options for added income from your portfolio. We don’t want you to just generate good gains and income from your factor-based approach; we also want you to keep the fruits of your investment labor by showing you how to use brokerage orders and tax strategies. Lastly, the book offers a wealth of resources and sites so you can keep learning about the new innovations, strategies, and tactics for successful factor-based investing long after you read your last chapter.
Foolish Assumptions
In writing this book, we wondered what a potential reader would need to know to find this book interesting. Here are some of the assumptions we came up with about you:
You have an interest in getting better at investing.
You are a novice or intermediate portfolio manager seeking reliable ways to enhance portfolio performance.
You have experience with the stock market but want to do better.
You are a financial planner or financial consultant seeking better ways to manage stocks and ETFs for yourself or a client.
Icons Used in This Book
In the margins of the book, you’ll find these icons helping you out:
Whenever we provide a hint that makes an aspect of factor investing easier or potentially more successful, we mark it with a Tip icon.
The Remember icon marks paragraphs that contain a friendly reminder.
Heed the paragraphs marked with the Warning icon to avoid potential disaster.
Where to Go from Here
This book is designed so that you can quickly jump to a specific chapter or section that most interests you. You don’t have to start with the first chapter — although if you’re new to factor-based investing, we recommend that you do so. Understanding the foundation of factor-based investing (which we explain in the early chapters) helps you better apply the techniques that you learn in the later ones to the specifics of your investment activity. The great thing with this book is that even if you are still not sure how best to incorporate factors in your investing approach, we include coverage of factor-based exchange-traded funds (ETFs) that could do the heavy lifting for you.
You can also find the cheat sheet, complete with additional nuggets of information, for this book by going to www.dummies.com and searching for “Factor Investing For Dummies cheat sheet.”
Part 1
Starting with Factor Investing Basics
IN THIS PART …
Getting the lowdown on what factors are.
Get insights on why you should consider factors.
Learn which factors can work best for you.
Using factors without needing to time the market.
Chapter 1
Counting on Factor Investing
IN THIS CHAPTER
Understanding what factor investing is
How factor investing can benefit you
Identifying the various factors used
In recent years, the strategy approach of factor investing has been catching on and it may be something that could boost your personal approach in the financial markets. Factor investing takes into account decades of portfolio experience and market research regarding effective approaches to portfolio management that can remove the guesswork about which types of securities are best able to meet a particular investor’s needs.
Perhaps the simplest explanation for factors is that they can act like guard rails in your portfolio management choices. The growth in factor investing’s popularity is evident in the world of portfolio management. Financial assets managed under the mantle of factor investing grew from under $400 billion in 2013 to exceeding US $1.2 trillion in 2021. In this chapter, you see what the appeal is.
The Essentials of Factor Investing
Factor investing is an investment portfolio general strategy that favors a systematic approach utilizing 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 and macroeconomic factors. (Both of these are covered later in the section “Introducing the Factor Groups.”)
Style factors
seek to identify the relevant characteristics of the individual securities (sometimes referred to as
microeconomic
traits or characteristics). Examples are the stock’s volatility, market size, and valuation.
Macroeconomic factors
refer to the general market’s environmental and economic aspects. Examples are GDP (Gross Domestic Product) growth and inflation (for more details, see
chapter 11
).
Introducing the Factor Groups
There are two main category types of factors: style (sometimes referred to as microeconomic) and macroeconomic. Style factors are associated with the company (or investment vehicle) itself while macroeconomic factors are about the company’s economic environment. In both cases, the factors act as drivers for the returns (for the company’s stock appreciation, for example) for that particular asset.
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.
Value
Looking at value means typically looking at the company’s fundamentals. The fundamentals are the most important financial data of the company such as the company’s sales and net profits, balance sheet (assets and liabilities), and important ratios such as 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. (For more details, see Chapter 6.)
Value investing is a very important discipline for those seeking a safer, long-term approach to stock investing success. Many aspects of it are covered in Stock Investing For Dummies (written by one of the co-authors of this book) because value investing strategies (and their relevant factors) should be a prime consideration for long-term investors. The Intelligent Investor: The Definitive Book on Value Investing by Benjamin Graham — known as the “father of value investing” — is well worth reading, too.
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 (such as 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
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.
Quality
Quality is certainly joined at the hip with value. This factor should definitely be among your top three considerations — especially if you’re more risk-adverse as a long-term investor.
Quality is a reference to the financial strength of the company and you would see this through factors such as low debt-to-asset ratios, a high return on equity, and stable earnings growth.
Dividend
Dividends are payouts to shareholders from the company. They are typically paid quarterly and are a sign of long-term financial health when the company has been paying dividends over an extended period of time (years and decades), and these dividends are paid reliably and are increased over time.
Dividends should be among the prime factors considered, especially if you seek income and also want to reduce risk and volatility. Dividend payouts are typically seen as a tangible expression of financial strength and during times of market decline and stress, dividend-paying stocks tend to rebound well.
Additionally, the long-term market studies strongly point out that dividends over an extended period of time tend to match or exceed the rate of inflation so this factor tends to add the bonus feature of dealing with inflation (a macroeconomic factor).
Growth
The growth factor highlights the measure of change in sales and earnings by the company in relation to its group (such as 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
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.
Momentum
This type of factor is a better consideration if you’re an experienced investor and/or speculator seeking short-term results.
Momentum is the reference to how well the stock’s price has moved upward in a given period of time (such as six months or a year) versus its peers in that particular category. Some short-term focused investors and speculators believe that if a stock is performing much better in a bullish trend (stock market prices are trending upward) that it will continue to do so in the near term. In that case, it would provide superior short-term gains versus its peers.
Although the momentum factor certainly bears this out, long-term investors should be wary. Just because a particular stock exhibits above-average upward movement, it doesn’t mean it will stay that way. It also doesn’t mean that the stock is an appropriate selection. In the past, there have been many poor-quality stocks that have exhibited great momentum in the short term but then declined significantly.
Internet and high technology stocks exhibited powerful momentum during 1999–2001 but had stomach-churning declines during late 2001 to early 2002. Some went bankrupt.
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. (Chapter 11 goes into more detail).
Economic growth (GDP)
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
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 2021–2022 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
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.
An Example of a Factor-Based Portfolio
You probably wonder how using a factor-based portfolio may differ with a traditional (or non-factor) based approach.
For decades, one of the simplest portfolio construction was 60 percent stocks and 40 percent bonds. After that simple diversification of two different asset classes, there may be diversification with each asset class.
The stock portion may have a mix of large-cap stocks (stocks with a market valuation, for example, exceeding $50 billion), mid-cap stocks (stocks in the $10–$40 billion range),and small-cap stocks (stocks with a market valuation under $10 billion). The bonds may be a mix of investment-grade corporate bonds.
The factor-based approach would make portfolio choices based on investment characteristics that have performed better than a random mix of securities. The stocks would be selected based on style factors such as value and quality so that selections are more optimal given the general market conditions at that time. If the general market was experiencing inflation, then inflation factors would be used to select stocks that perform better than average in an inflationary environment. The inflation factor is a macroeconomic factor described earlier in this chapter.
The bonds portion of the portfolio would also be viewed through the prism of appropriate factors. If you’re seeking safety, low-risk factors, such as short bond maturities and high bond ratings, limit your market risk.
The Upside and Downside of Factor Investing
Diversification is a rock-solid never-ending part of the foundation of successful investing (especially stock investing). Choosing the stocks of financially sound public companies (they have “good fundamentals”) that are varied (diversified) among different industries is an important long-term consideration. Factor investing helps to take this approach to a more effective level by reducing risk and enhancing returns.
Factor investing may sound attractive because it has so much weight behind it from academic studies and market data research. But it’s far from perfect because not all factors can work well consistently, as the market can change quickly and make one factor turn from a positive to a negative.
Take, for example, those investors who embrace the size factor in their approach. This factor puts much emphasis on small-cap stocks that may work well during a robust bull market, but you could get hammered during an unfolding bear market.
The other side is if you choose an approach that works well during a bear market but that leaves your portfolio underperforming during bullish times. The value investing factor, for example, may work out fine during a bear market or a sideways market but it won’t be optimal during a roaring bull market when value stocks lag the performance of growth-oriented choices.
Have a mix of factors working for you. Just as diversification works well with different asset classes in your overall portfolio, a mix of factors work out better in the long term versus too much reliance on a single factor approach.
A portfolio approach with a single factor will make you look like a genius if that factor is shining bright but you will see negative returns if that factor is (temporarily) out of favor with current market conditions.
Factor Investing through ETFs and Mutual Funds
For some folks, dealing with constructing a portfolio with an optimal balance of factors may seem daunting. You can put a factor investing strategy in place by choosing funds that adhere to factors. Exchange-traded funds (ETFs) and mutual funds have emerged in recent years that make it convenient to do a factor-based approach. You can find EFT at www.etfdb.com and mutual funds at www.mutualfunds.com.
Chapter 2
Why Use Factors?
IN THIS CHAPTER
Choosing the factor approach for your investments
Being disciplined in your approach
Understanding the models that make factor investing work: CAPM and FAMA
Factors can help you build a portfolio designed for your unique risk tolerance, investment time horizon, and financial goals using characteristics that history shows lead to consistent outperformance. An investment time period is the timeframe you expect to hold an investment, usually short (less than 5 years), intermediate (5–10 years), or long term (more than 10 years).
In this chapter, we show you how factor investing provides a building block that gives you the best odds of reaching retirement and income goals successfully. It helps improve portfolio results and reduces volatility. Factor investing, done right, enhances diversification in a way that lowers risk without sacrificing returns, by placing your investment eggs in many baskets to help ensure positive results!
Following a Systematic Approach
In a nutshell, factor investing is about defining and following a set of proven guard rails that keep your portfolio on track. Using a factor strategy not only gives you better returns, but delivers them more consistently while also protecting you from the dangerous pitfalls and mistakes that get other investors in trouble.
Leveraging the power of a persistent strategy
Investors worldwide have always sought the secrets that would help them invest right alongside legendary investors such as John Templeton, Warren Buffett, Jesse Livermore, Benjamin Graham, and John “Jack” Bogle.
Investing systems and rules have come and gone over the years, because it turns out many of them worked only in specific markets and just for a few years. These strategies picked up on short-lived trends and rules in stocks that were true only for a limited time due to certain conditions unlikely to repeat.
When you’re investing based on factors, you’re interested in a persistent strategy — one that can deliver results in the future.
By figuring out the themes, characteristics, and properties common to winning investment, or factors, you can discover a set of rules to create higher-performing portfolios. But how do you even try to comb through the mountains of market data over the last 100+ years to find what works?
Well, it turns out that you’re in luck! In the last few years, financial academics have been hard at work doing just that — distilling these factors into useful sets of rules that you can put to work in your portfolios today.
Though nothing works 100 percent of the time, especially over shorter periods, factors are most effective when combined with other factors in a master strategy. This has the effect of loading the dice in your favor.
Saving time
Time is money, the old saying goes, and investors since the ancient Chinese rice traders have always looked for ways to save time by streamlining and systematizing their trading and investing decision processes.
We all have busy lives, jobs to get to, kids to take to after school sports, and a million other things. A factor investing strategy can help improve your life by helping you make best use of your time and energy.
Jim used factor investing to save time during the COVID-19 market bottom in March of 2020. He needed an approach that identified resilient stocks and funds most likely to benefit from a market rebound, while also giving clients confidence in the historical reliability of these stocks to survive and thrive the unprecedented economic and market downturn everyone was experiencing as the world rapidly went into social distancing, quarantines, and government-mandated shutdowns.
He came up with a multifactor portfolio for new clients using the same principles in this book that was both sophisticated and easy to understand. This strategy gave them the confidence to enter the depressed stock market and stay on board for what turned out to be a profitable 18 months for investing, with many portfolios doubling in value.
Using modern advances
As investors, you always want to look for ways to take advantage of advances and breakthroughs in the investment field. Two trends that have come together to move investing forward have been computers and history; specifically, better methods of market data analysis and greatly expanded historical datasets to feed those computers.
Modern computers and new ways of crunching market data are at the forefront of the growing interest and advances in factor investing. Just as important is the expanding dataset as researchers and archivists have combed through old ticker tapes, micro-fiche and ledgers to complete the historical dataset of stock prices and company data; in some cases, right back to the Buttonwood Agreement that pre-dated Wall Street.
What is the Buttonwood Agreement? It’s a single-page document that started the New York Stock Exchange 230 years ago on May 17, 1792, when 24 merchants and brokers met under a buttonwood tree and put their signatures to a set of rules and safeguards for trading. The meeting was necessary to re-establish public confidence in markets after the infamous Financial Panic of 1792 that had caused mayhem earlier that spring.
Investing options were limited back then. The only stock available was in the Bank of New York, The First Bank of the United States, some insurance companies, and Revolutionary War Bonds issued by Alexander Hamilton to help pay off the War of Independence from British rule.
Today, you can also take advantage of databases, services, and perhaps even pre-packaged investment products such as funds and ETFs that attempt to apply factor methodology in a practical way to select investments based on current stock and bond metrics.
Luckily, technology has made factor investing far easier and more cost effective than ever, as we detail in later chapters.
This enhanced dataset provides a richer and more complete testing ground to ferret out meaningful factors and to test existing assumptions more fully. This is an advance that you can benefit from!
VISITING WALL STREET
By the way, did you know you can snap a selfie in front of the buttonwood tree outside the NY Stock Exchange? It's the only tree in front of a building on Broad Street, and it's right across the street from the famous “Fearless Girl” statue. Pro-tip: While you're there, look closely at the cobblestones on Wall Street. Running right down the center of the street are post markers made of square wooden pavers marking what was once a Dutch defense wall, which is exactly how Wall Street got its name. Interestingly, the wooden pavers are a nod to a soon-discarded attempt in the late 1800s to build quieter New York streets by replacing cobblestones with hardwood pavers.
Following proven guidelines that work
Even a broken clock is right twice a day, and, like a coin toss, any system can come up with a winner or two from time to time. As an extreme example, a rules-based system (factor) that consisted of “sell all U.S. stocks and buy bonds” may have worked very well as a factor from September 1929 until July 1932 but this was only due to the stock market crash that kicked off the Great Depression. Using this factor after 1932 would have been a recipe for disaster and decades of underperformance! The point here is that you’re looking for guidelines that provide a more universal advantage, and are not dependent on a specific set of historical circumstances.
The best factors you’re interested in work in many different markets, countries, and decades. They aren't just one-trick ponies that have shown results once or twice in history, perhaps by chance or due to unique circumstances. You want rules that operate more broadly and dependably.
Following a disciplined core strategy
The most successful investors have a disciplined strategy driving their success. Incorporating factors into your investing adds not just a methodology for investment selection but also discipline to portfolio activity as it helps you determine what to buy, sell, or hold, and gives you the confidence needed to participate in the long term.
Protecting against emotional investing
The emerging field of behavioral finance says that regardless of how you design your portfolio, the major reason for your success or failure is your emotion-driven actions. In other words, if you want to be successful at investing, you have to protect against emotional investing, which results in buying high and selling low, repeatedly.
The long-running DALBAR study, which has been updated annually since the inception of the 401(k) over four decades ago, proves that this problem is widespread and damaging to wealth building. Investors lack discipline (of course it's not you, just other investors).
What is DALBAR? Located in Boston, DALBAR is one of the nation's leading independent research firms committed to raising the standards of excellence in the financial services industry. It compiles and analyzes mountains of data on mutual funds, life insurance, and banking products and practices. It has also been behind the nation's leading study on investor behavior for the past 28 years.
One of its most followed publications is the annual Quantitative Analysis of Investor Behavior (QUIB) Report, which measures how investors have performed with their actual investment portfolios versus how the funds they hold have performed during the same periods. You might think that investor performance and fund performance are the same thing, but DALBAR consistently demonstrates a devastating investor performance gap due to investors shifting money among their investments (for example, from stock into more conservative bonds or cashing out at exactly the wrong times).
Compounded over the years, this performance gap is devastating, costing many investors literally hundreds of thousands — or even more — in retirement dollars they could have enjoyed.
For example, its 2021 study (www.dalbar.com/catalog/product) shows that this performance gap jumped to a shocking 1032 basis points for 2021. 100 basis points equals one percent, so this represents a lag of 10 percent for investors versus the performance of the average fund they were investing in. Obviously, despite the recovery from the 2020 COVID-19 market lows, many investors bailed (perhaps believing the recovery was too good to be true) and then got back in at higher prices in the fall, only to experience a downtrend and realize they had once again bought high without benefiting from the previous gains.
In short, DALBAR's extensive research shows that investors are their own worst enemies. The results, as shown in Figure 2-1, are sobering and hard to dismiss as the researchers used real-time data from millions of investor-directed 401(k) accounts. DALBAR has concluded that as much as two-thirds of the market return investors should have enjoyed were squandered to emotional investing — selling into fear after downturns, and buying into euphoria after upturns. The problem, of course, is that investors end up bailing near the bottom, when they've had enough pain, and buying again near the top of the market cycle, when they can't stand to miss out anymore. These mistakes get compounded over the years,and become even more damaging.
The results are similar in every annual update of the DALBAR study. In short, it turns out that most investors are doing exactly the opposite of what they need to do to build wealth. They are buying high and selling low.
A factor-based approach helps you avoid becoming an emotional investor. A portfolio strategy based on factors (ideally a diversified combination of multiple factors) can provide discipline, and powerful protection against emotional investing by offering a portfolio with which an investor can feel confident riding through inevitable downturns on the way to new highs. Only historically persistent factors can provide this sort of assurance, enabling investors to achieve their financial goals and helping to make sure their emotions don't cause them to outlive their assets.
Source: https://www.maendelwealth.com/blog/rising-rates-let-the-game-come-to-you
FIGURE 2-1: DALBAR.
