Three-Factor Model of Portfolio Management
Three-Factor Model is an extension of Capital Asset Pricing Model (CAPM) used to determine the return and risk associated with a portfolio management. It was developed by Eugene Fama and Kenneth French in 1993. Complicated than CAPM, the Three-factor model is more accurate as it explains more than 90% of portfolio returns (compared to around 80% of CAPM).
When determining returns, Three-Factor Model considers two more factors other than market risk (beta). They are size (market capitalization) and value (book/market ratio) factor. The reason for this is the fact that value stocks and small cap stocks regularly outperform markets and large value stocks. As per the model small value stocks usually have highest-risks and highest-returns. Although not resolved correctly, the possible reasons for the out performance of this small cap and value stocks are (1) because of the excess risks these stock carries and (2) because of mispricing demanding later price adjustments.
Studies have shown that mutual funds and portfolios which follow three-factor model outperform most others. This led to the enhanced adoption of this model by more and more funds. Many investors also adds custom factors (eg: credit risk) to the model for enhanced performances. One thing to remember is the high volatility associated with small caps and value stocks; investor must carefully diversify the portfolio to attain more than average risk with desired risk level.
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When determining returns, Three-Factor Model considers two more factors other than market risk (beta). They are size (market capitalization) and value (book/market ratio) factor. The reason for this is the fact that value stocks and small cap stocks regularly outperform markets and large value stocks. As per the model small value stocks usually have highest-risks and highest-returns. Although not resolved correctly, the possible reasons for the out performance of this small cap and value stocks are (1) because of the excess risks these stock carries and (2) because of mispricing demanding later price adjustments.
Studies have shown that mutual funds and portfolios which follow three-factor model outperform most others. This led to the enhanced adoption of this model by more and more funds. Many investors also adds custom factors (eg: credit risk) to the model for enhanced performances. One thing to remember is the high volatility associated with small caps and value stocks; investor must carefully diversify the portfolio to attain more than average risk with desired risk level.
NobleTrading.com OffersOnline Stock Trading, Online Options Trading
Online Futures Trading, Online Forex Trading
Worldwide Brokerage Service, Day Trading Brokerage
posted by Daniel Pipitone at
5:49 AM
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