Understanding the Fama-French Three-Factor Model, its calculation, and its significance in financial analysis
The Fama-French models, introduced by Nobel Laureate Eugene Fama and researcher Kenneth French, have significantly impacted the world of finance and long-term investing. Originally presented in 1992 as the Three-Factor Model, it was expanded in 2014 to become the Five-Factor Model.
The Three-Factor Model comprises three key factors: size (small minus big), value (high minus low), and market excess return. This model improves upon the Capital Asset Pricing Model by incorporating size and value risk factors, suggesting that stocks of smaller companies and those with high book-to-market ratios tend to offer higher expected returns over the long run.
The Five-Factor Model builds upon the Three-Factor Model, adding two new factors: profitability and investment. The profitability factor, a new addition compared to the original Three-Factor Model, refers to the concept that companies reporting higher future earnings have higher returns in the stock market. On the other hand, the "investment" factor proposes that companies investing heavily in growth projects may face stock market losses.
One of the key implications of the Fama-French models is the enhanced risk-return understanding for long-term investors. Accounting for size and value factors helps to better explain cross-sectional variations in returns and improves portfolio construction strategies. Systematic risk factors beyond the market are also revealed, implying that ignoring these factors may lead to underestimating expected return or mispricing risk.
Long-term investors can strategically tilt their portfolios toward small-cap and value stocks to potentially enhance returns, accepting the associated higher risk. This highlights the importance of factor-based investing to achieve better risk-adjusted performance beyond market index investing.
Research using extensions of the Fama-French factors shows differential sensitivity by firm size to external shocks like monetary policy changes, which can inform long-term risk assessments for portfolios concentrated in certain factor exposures.
In summary, the Fama-French models encourage long-term investors to diversify their risk exposure across market, size, and value premiums rather than relying solely on market risk. This enables more informed decisions about expected returns and portfolio risk profiles over extended horizons. Investors with a long-term time horizon of 15 years or more will be rewarded for losses suffered in the short term. However, they must be able to ride out the extra volatility and periodic underperformance that could occur in a short time.
The Fama-French Five-Factor Model explains more than 95% of the return in a diversified stock portfolio, similar to the original Three-Factor Model. This empowers investors to tailor their portfolios to receive an average expected return according to the relative risks they assume, given the explanatory power of the Fama and French Five Factor Model.
- In the world of crypto finance, some investors may consider the Five-Factor Model to strategically allocate their portfolio, as it explains over 95% of the return in a diversified stock portfolio.
- While trading various tokens in the crypto market, understanding the profitability factor from the Five-Factor Model could prove beneficial, as it suggests that companies reporting higher future earnings have higher returns in the stock market.
- When evaluating potential investment in a crypto project, one might need to pay attention to the investment factor of the Five-Factor Model, which proposes that companies investing heavily in growth projects may face stock market losses, indicating potential risks associated with such investments.
