What Is Factor Investing
Factor investing selects stocks based on characteristics (factors) shown to drive outperformance, such as value, size, momentum, and quality. We explain the main factors and how to apply them.
What makes a group of stocks beat the market?
Instead of picking stocks on gut feeling, factor investing selects stocks based on characteristics (factors) that research has shown to drive outperformance over time. It is a systematic approach, sitting between active and passive investing.
The main factors
Financial research has identified several durable factors:
- Value: cheaply valued stocks (low P/E, P/B) tend to outperform long term. Related to value vs growth investing.
- Size: small-cap stocks tend to deliver higher returns (with higher risk).
- Momentum: stocks rising well tend to keep rising β the basis of momentum trading.
- Quality: businesses with high, stable profits and low debt (high ROE) tend to be more durable.
- Low Volatility: less volatile stocks sometimes deliver better risk-adjusted returns.
Why factor investing is appealing
- Systematic, less emotional: selecting by clear criteria instead of "feel" β reducing bias.
- Evidence-based: the factors are validated on long data.
- Diversifying return sources: combining multiple factors keeps a portfolio from depending on one market type.
- "Smart beta": many ETFs apply factor investing at lower cost than traditional active funds.
Important notes
- Factors are cyclical: no factor wins forever β value can lag momentum for years then reverse. Combining factors reduces this risk.
- No short-term guarantee: factor investing is a probabilistic, long-term edge, requiring patience through periods when a factor "underperforms."
- Beware chasing the just-winning factor: buying a factor just because it is hot is a mistake related to recency bias.
- Discipline required: holding the strategy through tough periods is the hardest part.
How to apply it
- Through factor ETFs: the simplest way for individual investors.
- Combine with asset allocation: factor investing is a way of selecting stocks within the equity class, not a replacement for allocating across classes.
- Accumulate steadily: combine with DCA to maintain discipline.
Conclusion
Factor investing selects stocks based on factors shown to drive outperformance: value, size, momentum, quality, low volatility. It is a systematic, evidence-based approach that reduces emotion. But factors are cyclical and offer no short-term guarantee β combine multiple factors, keep long-term discipline, and avoid chasing the just-hot factor.
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