Beating the market is the holy grail of investing—a nearly impossible quest that leaves many battered along the way. But while true market-beaters are rare, there is a more calculated, less mystical way to tilt the odds in your favor: factor investing. No, this isn’t about some secret sauce cooked up in a dark corner of Wall Street. It’s about being systematic, playing the long game, and—here’s the kicker—not trying to outguess every next market move. Let’s dive in, with both caution and some much-needed sarcasm, into how to take a shot at beating the market intelligently.
What the Heck is a Factor Anyway?
A factor is not the stuff of financial wizardry; it’s a characteristic that explains why certain stocks or bonds might outperform over time. Think of it as the difference between gambling in a casino and learning to count cards (and no, I don’t mean cheating). Factors have been identified by mountains of research as persistent drivers of returns. You know, things like value (buying stuff cheap) and quality (buying good stuff).
But not just any “factor” will do. A true factor must be three things: intuitive, consistent, and persistent. If it’s not intuitive—meaning, there isn’t an economic rationale supporting the theory; it is just noise. Like- if the NFC wins the Super Bowl it foretells a rise in the stock market- it is just coincidence. If it’s not consistent, it’s just luck masquerading as skill. And if it’s not persistent, congratulations, you’ve found something that worked last year. Pat yourself on the back and move on.
The Red Flags: Fake Factors & False Friends
Some “strategies” dress up as factors but fail these tests. A strategy that isn’t backed by solid economic rationale—one where you’re left scratching your head thinking, “Wait, why does this work again?”—is a non-factor. A famous example? Anything that sounds too clever or depends on too narrow a data set. Remember the strategy of investing in companies based on the last digit of their stock price? Believe it or not, this was a strategy assumed to work by many investors based on limited datasets and frankly – randomness and superstition.
What’s worse? When factors are too correlated with each other. The whole point of factor investing is diversification. If all your so-called “factors” move together, you’re just making a bigger bet on the same thing. And that’s where multicollinearity comes into play—a fancy word for when factors aren’t as independent as you thought. Ever notice how “value” and “quality” sometimes overlap? Sure, it makes sense, but it doesn’t mean you’re doubling your chances. You’re just doubling down on factors with similar traits.
The Real Deal: Factors That Have Beaten the Market
Let’s talk about the all-stars—factors that have beaten the market, and not just on the weekends when nobody’s looking. In their study, “Superstar Investors,” Villalon, Brooks, and Tsuji found that many famous investors rode these factors to victory over the long haul. Buffett, Soros, Peter Lynch and Bill Gross, their outperformance largely comes from- factors! And guess what? You don’t need a cape to use them too. Here are the core factors:
-Value: Buying what’s cheap and holding your nose through the rough patches. It’s not glamorous, but over time, the market wakes up and realizes it overreacted to bad news.
– Quality: This is like hiring an A+ student to do your homework. Companies with high profitability, low debt, and strong fundamentals tend to stay solid, even when others crumble. No drama here—just good, old-fashioned resilience.
– Low Volatility: Everyone loves a high-flyer, but guess what? Boring, low-volatility stocks have quietly outperformed their more exciting cousins. Why? Because investors overpay for the thrill, while the steady tortoise plods along to victory.
– Momentum: Buy high, sell higher. Sounds crazy, right? But it turns out stocks that have been winning tend to keep winning. It’s like betting on a horse that’s already ahead—at least for a while. The trick? Knowing when to jump off the train.
These factors have shown persistence across decades, geographies, and market conditions. Sure, there will be periods when they underperform (nothing’s perfect), but the long-term evidence is compelling.
Diversification: The Secret Sauce (Hold the Ketchup)
Here’s where it gets interesting: combining these factors offers more than the sum of their parts. They’re generally non-correlated, which means they zig while others zag. But be careful not to let them blend too much—remember that pesky multicollinearity? It’s like mixing red and blue and being surprised you got purple. Combining value and momentum, for instance, gives you diversification, while combining value and quality might give you a weaker mix than you hoped.
The Long Game: Why Patience Wins
Now here’s the hard part: sticking with it. Factor investing is not about catching lightning in a bottle; it’s about being consistent, disciplined, and, most importantly, patient. There will be years when it feels like nothing’s working, when you start wondering if that random astrology strategy wasn’t so bad after all. But as Villalon, Brooks, and Tsuji showed, factor exposure pays off over the long term. It’s about staying the course, even when the ride is bumpy.
So, want to beat the market? Forget chasing fads and flashy predictions. Stick with factors that make sense, that have stood the test of time, and that, while not foolproof, give you a fighting chance. Factor investing is less about “getting rich quick” and more about “getting rich steadily.”
If you want to learn more about how we use factors to build smarter portfolios, let’s chat. Because while we can’t promise you’ll beat the market every year, we can help you approach it with a better plan than most.
John Grubbs, CAIA®, AAMS®
Sources:
Brooks, Jordan, Daniel T. Villalon, and Severin Tsuji. “Superstar Investors.” Journal of Portfolio Management 46, no. 5 (2020): 17-33.
Fama, Eugene F., and Kenneth R. French. “Common risk factors in the returns on stocks and bonds.” Journal of Financial Economics 33, no. 1 (1993): 3-56.
Black, Fischer, Michael C. Jensen, and Myron Scholes. “The capital asset pricing model: Some empirical tests.” In Studies in the Theory of Capital Markets, edited by Michael C. Jensen, 79-121. New York: Praeger, 1972.
Haugen, Robert A., and A. James Heins. “On the evidence supporting the existence of risk premiums in the capital markets.” Working Paper, University of Wisconsin, 1975.
Novy-Marx, Robert. “The other side of value: The gross profitability premium.” Journal of Financial Economics 108, no. 1 (2013): 1-28.
Jegadeesh, Narasimhan, and Sheridan Titman. “Returns to buying winners and selling losers: Implications for stock market efficiency.” Journal of Finance 48, no. 1 (1993): 65-91.
Definitions:
Covariance: Covariance measures the joint variability of two random variables.
Correlation: Correlation is the normalized version of covariance, and measures to what degree the returns of the two assets move in relation to each other
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