Factor-based investing - a primer

Almost every investor has heard the name of Warren Buffett. Buffett, often referred to as the greatest investor of all time, is known for his portfolio performance and investing wisdom, which he frequently shares publicly. Several books have been written about his 'secret sauce' for investing success and have attempted to explain it through a mix of fundamental and psychological factors. The academic community, too, has researched the secret sauce - characteristics of securities that explain outperformance against markets (also called 'premiums'). These characteristics or properties can be called 'factors'. The birth of 'beta' Before multi-factor models, finance theory (in the early 1960s) asserted that stock returns are responsive to broader market movements. This model suggested that a single factor - market exposure - drives the risk and return of a stock. Known as the 'capital asset pricing model' or CAPM, it stated that returns from individual securities depended only on 'non-diversifiable risk' - denoted by beta (β). Any return that could not be explained was due to company-specific factors. Beta is simply a ratio of the expected return from a security over the risk-free rate and the expected return from the market over the same risk-free rate. When the 'security' is the market, i.e., all the stocks in the market, the beta will be

This article was originally published on July 01, 2024.