Why do factors work?
Factors work, the evidence is out there. But why they do may not be intuitively obvious. After all, if anyone can profit simply by picking stocks with certain quantitative criteria, surely hordes of investors would pile in to this strategy and in doing so would ‘arbitrage’ the profit potential away?
It is true that not all investors who have tried to harness the power of factors have been successful. There are cases in which once-secret investment strategies become common knowledge and the profit opportunity vanished. [1]
Yet over the decades, a core set of factors related to quality, value and momentum have delivered persistent outperformance. Understanding the intuitive reasons why these methods work gives confidence when applying them in your investing. The answer always falls under two main themes, both ultimately linked to enduring human psychological tendencies.
1. Risk: Factors can reward you for taking on risk
Just as insurers earn a premium for insuring risks, factor investors earn a premium that pays them for the potential risk of enduring a bad time in future. This is notably the case with value investors, who own troubled companies and take on the risk that their shares may underperform or go bust if a recession returns. They earn a significant premium in the meantime to make up for that risk.
2. Behaviour: Factors are driven by systematic market mis-pricings
It's important to understand the biases we have against investing in high quality, cheap or rising shares. They can be psychologically challenging to buy for a few reasons:
Quality stocks are boring: good stocks are often rather predictable. Investors prefer exciting stories with unpredictable outcomes. This regularly leads to quality stocks trading too cheaply versus story stocks.[2]
Value stocks have problems: cheap stocks can suffer from suspect business models or ongoing problems. Investors become overly pessimistic about the prospects for unfashionable, out of favour, distressed stocks and struggle to believe that their low prices will recover. This leads to over-reaction, excessive selling pressure, delayed buying and persistent underpricing.
Momentum stocks are scary: strong stocks either break out, or trend to price levels they've never reached before. This makes investors feel they've missed the boat. Ironically, this means they may not be priced highly enough due to systematic under-buying.[3]