Factor Investing and Its 5 Essential Principles
The five essential principles of factor investing are: (1) choose factors that have shown persistent return premiums, (2) diversify across factors with low correlation to each other, (3) select stocks with consistent, rules-based criteria rather than judgment calls, (4) hold factor exposures for the long term, and (5) review and adjust the process regularly. Common factors include value, momentum, size (small cap), quality, and low volatility.
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Factor investing explains stock returns as exposure to a few common characteristics, or factors. It builds on academic asset-pricing research, including William Sharpe's work on market risk (beta) and later research by Eugene Fama and Kenneth French on the size and value factors. Investors tilt a portfolio toward the factors they believe will be rewarded over time.
What are the 5 Essential Principles of Factor Investing?
The 5 essential principles of factor investing are the following:
Principle 1: Uncover Risk Factors with the Potential to Help Increase Returns
The first principle of factor investing is to choose factors that have historically earned a persistent premium over the broad market across long periods and different markets, such as value or momentum. A factor that worked only in one short sample is more likely to be a statistical accident.
Principle 2: Low Correlation and Diversification Across Factors
The second principle is to spread capital across several factors whose returns have low correlation with each other. Value and momentum, for example, often perform well at different times, so combining them can reduce portfolio volatility compared with holding either alone.
Principle 3: Invest in Factors with Unbiased Approaches
The third principle is to select stocks with fixed, rules-based criteria (for example, the cheapest 20% of stocks by price-to-book) and apply them consistently. Rules remove the personal biases that lead investors to override a screen when a stock "feels" wrong.
Principle 4: Build Deep Beliefs for Long-term Returns
The fourth principle is to hold factor exposures for the long term. Every factor goes through multi-year stretches of underperformance, and investors who abandon a factor during those stretches tend to miss the recovery. Only invest in factors whose economic rationale you believe in strongly enough to stick with.
Principle 5: Review and Adjust your Process Regularly
The fifth principle is to review the process on a schedule: rebalance holdings back to the factor rules, check that factor exposures are what you intended, and watch for trading costs that erode the premium. Adjust the rules deliberately, not in reaction to a bad quarter.
Building factor screens in Excel with MarketXLS
The MarketXLS Excel add-in returns factor inputs into cells so you can rank stocks with your own rules: for example =PERatio("AAPL") or =BookValuePerShare("AAPL") for value, =MarketCap("AAPL") for size, =Beta("AAPL") for low volatility, and =QM_GetHistory("AAPL") for price history to calculate momentum. Factor premiums are historical and not guaranteed; this article is educational, not investment advice.
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