Chicago Booth’s Eugene F. Fama and Dartmouth’s Kenneth R. French pioneered the use of factors to explain excess returns of stocks and other assets, and they have long maintained that stocks have only a few common sources of risk. Fama and French first proposed three and have since allowed for five, with the occasional appearance of a sixth factor—even as other researchers have investigated hundreds of potential factors affecting equities returns. (See “The 300 secrets to high stock returns,” Summer 2018.)
But what’s the best way to analyze factors and to determine whether these five—or others—really do explain returns? Researchers use myriad statistical methods, but Fama and French argue in favor of expanding on an earlier approach of describing returns across stocks, which they say could improve upon a widely used method that Fama helped develop.
Fama and French published their three-factor model in 1993, arguing that beta, size, and value can be used to explain stock returns. In 2015, they added profitability and investment as factors. To analyze the factor models, they relied largely on cross-section regressions that were pioneered in 1973 by Fama and James D. MacBeth....MORE
The five factors driving returns
Market risk (beta): The riskiness of a stock compared with that of its benchmark. Stocks with less market risk have tended to outperform over time.
Size: The market capitalization of a stock. Small-cap stocks have tended to outperform large-cap ones.
Value: The measurement of a stock by its price-to-book ratio or other ratios.
Profitability: The operating profitability of a stock’s underlying company. Stocks of profitable companies tend to perform better.
Investment: The total asset growth of a stock’s underlying company. Stocks of companies with growing assets do worse.
*Momentum: The tendency of stocks that have outperformed in the past to post strong ongoing returns.
*Unofficial sixth factor, per Fama and French
Recently:
"Is semi-variance a more useful measure of downside risk than standard deviation?"
...If yous see them together at some Chicago dive bar, Fama is the one with the Nobel around his neck, French the one saying "For Chrissakes Gene."
For more on semi-variance here's 2014's "The Equation that Will Change Finance"
And on Momo Mamas a couple links with the second containing links within links and a huge warning:
Alice In Factorland: Can Momentum Investing Be Saved?—Arnott et al
"Two Centuries of Momentum"
The "300 secrets" article has a sub-head worth noting:
*Caveat: Most of them probably won’t workHas the hunt for investable factors gone too far?
There’s a cycle in the finance world whereby good ideas become products, which sell well and spur demand for more good ideas. Current case in point: the cycle involving investable factors....
See also Julius Caesar, Act 4 Scene 3 Page 11:
Brutus:You don't know how much willpower was required to resist using the quote yesterday.
There is a tide in the affairs of men,Which, taken at the flood, leads on to fortune;Omitted, all the voyage of their lifeIs bound in shallows and in miseries.On such a full sea are we now afloat,And we must take the current when it servesOr lose our ventures.
