Eugene Fama and Kenneth French, professors at the University of Chicago Booth School of Business, expanded on the research into diversification, identifying three key factors that affect a portfolio’s returns. You can think of each of these factors as a type of investment risk: Market Factor, Size Factor, and Value Factor.
Market Factor: The Market Factor tells us it is inherently riskier to invest in the stock market than in fixed income instruments, such as U.S. Treasuries (bills, notes, and bonds). Stock purchases demand a higher return because more risk is involved. If stocks didn’t offer a higher return than Treasuries, everyone would invest in the much safer T-Bills. But stocks have the potential to provide a higher rate of return than fixed income instruments. So the market risk factor informs your decision as to how to divide your portfolio between stocks and bonds.
Size Factor: The Size Factor takes into consideration the size of the companies in which you’re investing. Small companies generally have the potential for higher returns than do large companies, but are a riskier investment. Larger companies are less likely to experience tumultuous business changes, making them appear more stable. In addition, they’re typically more capable of weathering adverse economic conditions and unexpected events. Because of their lower level of risk, the market demands less return on investments in large companies.
Value Factor: The Value Factor refers to the extra risk exposure, and the extra risk premium, of investing in high book-to-market or “Value” stocks. High book-to-market stocks refer to companies with a lower market price than other companies of similar size. These types of companies are usually ones that are experiencing lower earnings and some kind of financial distress. As a result, they’re riskier and offer investors the potential for a higher return.
Research suggests that it is sensible to shift money into companies just when they are having a hard time. That may seem counterintuitive, especially when comparing a “Value” company to one that has better growth and better returns.
In contrast, a company that is doing well has already been rewarded with a higher stock price (also as per the Efficient Market Hypothesis). So if there’s a marked improvement in the distressed company, the upside will be much higher relative to a proportional improvement in the healthy company. That’s why people on reality shows buy run-down houses, fix them up, and then “flip” them at a significant profit. It’s also why no one really knows when a stock is “undervalued.”
The Three-Factor Model shows us that by systematically exposing a portfolio to the three risk factors – Market Factor, Size Factor, and Value Factor – it is possible to increase expected your returns without increasing risk.