Understanding factors leads to better investment strategies.
This article originally appeared in the October/November 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Why do some assets yield higher returns than others? Factors provide an explanation. In a nutshell, factors represent the risks that people care about. The stronger an asset is related to a factor, the riskier it is, and because of this, people will demand a higher rate of return. In order to understand factors, I provide a basic review of asset pricing theory, discuss the most important empirical findings in the academic literature, and explain why people should care about factors when deciding on an investment strategy.
Asset Pricing Theory
One basic prediction of asset pricing theory is that assets are more valuable if they are expected to yield higher future payments. In other words, they (directly or indirectly) give the owner the right to consume more goods and services. A stock’s payments, for example, are its dividends. Another prediction is that assets are more valuable if these payments come sooner rather than later.
A crucial characteristic of any asset is its risk— that is, uncertainty about its future payments. In general, people dislike uncertainty. But if an asset’s payments are more uncertain, will it be less desirable, priced lower, and have higher expected returns? An important prediction of asset pricing theory is that this is not necessarily the case: A risky asset should not be less valuable than a riskless asset, provided its risks are diversifiable.
Diversification means costless elimination of risk. Holding an asset with diversifiable risk should not increase the uncertainty of a portfolio; therefore, people should be equally happy to hold this asset and an asset that has no risk whatsoever. The risk of the overall portfolio is identical.
In contrast, suppose an asset’s payments are lower than expected exactly when your portfolio is doing poorly. In that case, adding even a small amount of this asset to your portfolio will increase the risk of your portfolio. This makes an asset less attractive.
Again, asset pricing theory predicts that the more undiversifiable risk an asset has the lower its price and higher its returns will be. High undiversifiable risk means that an asset’s performance is strongly correlated with the performance of a sensibly chosen portfolio. It is important to note that I am interpreting the term portfolio broadly. Think of your portfolio as consisting of the full collection of claims that enable you to consume. Consumption, likewise, should be broadly interpreted to mean anything that people value. An important component of many people’s (broad) portfolios is their capacity to earn income from a job.
An unconventional example is the weather. Every day, this “asset” yields a “payment” that we “consume.” Some days this payment gives us more pleasure than others. Hypothetically, financial assets that perform poorly whenever the weather is bad might be valued less. It is doubly frustrating if stocks are down when it is raining.