Three Factor Model

To understand the three factor model, it makes sense to review how it came about. The three factor model is basically an expansion of the Capital Asset Pricing Model (CAPM). CAPM was the work of academics in the 1960’s which originally established the relationship between risk and reward. In the investment world, certain assets are deemed to be risk free. The academic community has long defined the 30 day T-Bill as a risk free asset. So whatever yield an investor could achieve by buying 30 day T-Bills would define the current risk free rate of return.

If an investor wanted to earn more than the risk free rate of return, he would have to take on more risk. CAPM is a single factor model and identified “Beta” as the single factor responsible for risk, and therefore reward, in any given investment. Beta is defined as a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Capital Asset Pricing Model

The market is deemed to have a Beta of 1.0. An investment with a beta coefficient of less than 1.0 would carry less risk than the market. An investment with a beta coefficient of more than 1.0 would carry more risk than the market.

For example, an investment with a Beta of 0.8 would carry 20% less risk than the market and an investment with a beta of 1.2 would carry 20% more risk than the market. Using this, investors could create portfolios that capture the appropriate level of risk for their liking. Click here to see an example.

CAPM was the most widely accepted and taught model defining investment returns for decades. Though it was a step in the right direction, this single factor model had flaws which made it incapable of explaining certain effects seen with actual market returns. Because CAPM (Beta) was only able to explain about 70% of the variability in market returns, academics set out to discover what other factors might play a role. In the early 1990’s Eugene Fama and Kenneth French published information that would evolve into the Three Factor Model. Fama and French are known for their research that identified two additional factors know as the “value factor” and the “size factor” which when added to CAPM explained over 96% of the variability in market returns.

Three Factor Model

Fama and French discovered that over time certain stocks tended to outperform the market as a whole. These types of stocks were small capitalization stocks and high book-to-market valuation stocks which are commonly referred to as value stocks. Historical data would show that each of these two types of securities would yield substantial return premiums over the market average.

Investors know that over time, stocks outperform bonds. Stock market data exists back to 1927. A review of that data shows stocks have outperformed the risk free rate of return by about 8% per year.

Thru their research, Fama and French also identified the size and value effects exhibited by markets. They found that small capitalization stocks and high book-to-market (value) stocks also tended to yield premium returns. Small capitalization stocks have outperformed Large Cap stocks by about 3.5% per year since 1927. Value stocks have outperformed growth stocks by about 5% per year since 1927.

Whereas the CAPM only explained about 70% of stock market returns, the Three Factor Model explains over 96% of stock market returns. The Three Factor Model is a useful tool for understanding stock market returns and building risk appropriate portfolios. This benefits investors because they no longer need to subject their portfolios to the voodoo investing styles of managers who act as if they can see into the future. Investors no longer need to rely on guesswork or black box formulas.

At PIG we construct our portfolios using a five factor model. This five factor model incorporates the three factors discussed above for stocks and two additional factors for bonds (quality and duration). The stock portions of our portfolios are designed to capture these return premiums in proportion to their historical magnitude. This disciplined approach to investing gives investors greater confidence in knowing what they own and what to expect based off of market performance. It removes the guesswork and black box formulas of most modern day managers.

Five Factor Model