Factor investment is a popular investment strategy where securities capable of offering high returns are selected. The two main factors which drives the returns of stocks are : macroeconomic factors and style factors. Some popular macro economic factors are inflation, liquidity, emerging markets, economic growth and style factors are value, momentum, quality, size etc. These factors have very low correlation with each other and therefore tends to perform well at different parts of economic cycle. Factor investing tends to design a well diversified portfolio with an aim of earning above market returns by managing risk in an optimum manner. Portfolio diversification is often done by investors in order to safely invest in market , but if a investor have chosen stocks which moves in lockstep then benefits of diversification can not be realized. For example : In a particular investor’s portfolio there is a mixture of some stocks and bonds which may decline in its value when certain market condition arises. Using factor based investing this risk can be eliminated.
Five key factors using which factor investing is formed are discussed below :
1) Size : In market there are three types of stocks : mid cap, small cap, large cap. With markets past performance it can be concluded that small cap stocks tends to give higher return than large cap stocks. Investors can look for small cap stock by checking its market capitalization.
2) Momentum : Stocks which have performed extremely well in past mostly offers high returns . Investors can check for price trends here to predict future returns.
3) Value : It aims to gain excess returns from stocks which are low priced as compared to their fundamental value . The information related to stocks can be learned by studying dividends, price to earning ratio, cash flow statements .
4) Volatility : Research says that stocks which are low volatile earns high returns than stocks which are highly volatile. Volatility of a stock can be measured by measuring standard deviation from 1-3 year time frame.
5) Quality : Stocks quality is decided by examining factors like debt, growth , cooperate governance and more. Investors can learn about quality of stocks by studying different financial factors associated with it.
Factors based investment has several advantages but it can be costlier at times. Investors should go for such type of investment strategy if they have good experience of trading in market and also have good knowledge about market and its different terminologies.
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