There Are 3 factors In a Diversified Portfolio, That Can Help Propel Portfolio Returns.According to Eugean Fama, Chicago's School Of Business & Ken French of Dartmouth.
There are three main factors1.Profitability, 2.Size, 3.Price-to-book value -that can help propel portfolio returns.
Based in Mountain Brook, Alabama, Paul works through DFPG to maximize your investment potential. Below, we discuss the three risk factors that can be utilized to propel portfolio returns.
Academic research has identified 3 equity dimensions, which may point to differences in expected returns. Investors can try to pursue higher expected returns by structuring their portfolio around these dimensions. Remember of course this is only a theory. Which was made famous by Eugene Fama and Ken French.
"The Profitability Premium" Factor.
Profitable companies tend to stay very profitable. In his research, Novy-Mark in a paper published in 2013, was able to document a strong relation between current profitability and future stock returns. That is, firms with higher profitability tended to have higher returns than those with low profitability. This is referred to as a profitability premium. This of course is a theory, and may not work all the time.
The Small Cap Stock Factor.
Small stocks act differently than larger stocks, and generally outperform them over a period of time (but at a higher risk). By factoring in "size" risk, portfolios that include a weighting of small cap stocks can out perform larger stocks over time. Remember this persons caveat " generally" which sometimes means I could be wrong.
Value Stock, Factor. Or High Book Value to Market price
The third factor, price-to-book value, compares the amount of volatility with value stocks in the market as a whole. Value stocks tend to be larger companies with lower earnings growth rates than growth stocks. They are also more likely to pay higher dividends, so their book value tends to be higher when compared to their price (BtM). Fama-French found that value stocks act differently than growth stocks, and that, over time, value stocks have outperformed growth stock, but again, at higher risk.
In summary, there are three main factors - profitability, size, and price-to-book value - driving expected returns in a portfolio. Because these three factors can determine more than 95% of the return of a diversified stock portfolio versus the market as whole, it is now possible for investment managers to engineer a portfolio in which investors receive an average expected return (above the guaranteed T-Bill rate) according to the relative risks they assume in their portfolios.
Disciplined investors accept the fact that there is risk in the markets and the chance of experiencing negative returns in their portfolio at one time or another is a very real likelihood. They know that the longer they hold their portfolio, the more likely they are to experience extended periods of negative returns. But they also know that the longer they hold their portfolio that is properly diversified with all risk factors considered, the greater the likelihood that their compounded annual return will be positive.