Investment today is an analytical affair even more than ever before. Many methodologies and scientific approaches to investment have been developed to boost the expected returns and mitigate the risks. One of these approaches is known as factor analysis.
Whether you are a qualitative or quantitative analyst, finance expert, or a newbie at investment analysis, it is worthwhile finding out or revisiting the key aspects of factor investing. Therefore, let us get straight to it.
Looking at the key factors
When doing factor investing or factor analysis, finance analysts look at the key factors that are associated with higher returns and lower risks. Thus, factor investing is a strategy that tracks the trends of such factors and provides the basis for investment decision-making.
Naturally, quite many economic, market and stock features may be considered such factors worthy of attention. To make things easier and more efficient investment analysts group some of these features and single out those that tend to be most indicative. Here, they follow the long tradition of factor analysis, which is utilized in many fields from social sciences to machine learning.
The factors for the factor analysis finance firms care the most about can be grouped into two major groups. The first is macroeconomic factors and the second is style factors. Let us look at the key factors within these two main categories that factor investors analyze and why they matter.
Macroeconomic factors are related to general economic conditions in which the company we are interested in has to operate. The most important macroeconomic factors include the following.
- Growth trends. If the economy is growing, consumer spending usually follows, which increases the profits for many companies and thus their stock worth. However, in periods of decline, consumers are unlikely to spend money on anything except necessities, which downgrades the value of the firms that produce products that people would love buying but can do without.
- Unemployment rates. Similarly, with fewer jobs, there is less extra money to spend, which directly affects the stocks of a lot of companies. Thus, unemployment rates tend to follow the growth trends although there might be divergences when looking at these rates for particular industries.
- Inflation. Even with low unemployment rates, when the prices go up, the purchasing power of people goes down. Which once again may negatively affect many companies, while increasing the value of those that deal in more necessary items for manageable prices. Inflation also affects style factors, which have to be taken into account.
- Fiscal government policy. When doing factor analysis, finance experts also look at the political side of the situation. Government decisions regarding taxes and business regulations impact how industries and markets will develop and thus the relative risks associated with particular stocks.
Style factors determine the risk and returns associated with the different asset classes. Some of the most important style factors are as follows.
- Value. This refers to the intrinsic value of an under-priced stock. Analysts aim to identify stocks that are worth more than the current price by looking at such variables as price-to-earnings ratio and dividends among others.
- Momentum. Stocks that have high momentum, that is, have exceeded their recent expectations tend to keep growing as they go forward. When identifying momentum investors look at the performance in the last period of up to a year.
- Volatility. This metric refers to the price dispersions of a particular asset, that is, how much the price has tended to move and deviate from the statistical mean. More volatile assets are considered riskier as their price changes are harder to predict.
- Quality. The quality of the asset is determined by looking at how stable the growth and the earnings are, the quality of the assets management, low debt, and similar features.
These are some of the main factors considered by investors and financial firms. Of course, when carrying out a thorough factor analysis, finance experts look at many more factors and metrics to arrive at the best investment decisions.
Why does it matter?
Factors investing is a strategy that usually chooses security over the expectation of fast and high returns. Thus, knowing the key factors that affect the risks of investment is crucial for a prudent investor.
However, even investors who want to diversify their portfolios and do not mind combining different styles and strategies can benefit from factor analysis. After thorough factor analysis, finance firms are capable of securely selecting different stocks and bonds to increase their long-term returns.
This in turn helps to avoid high losses due to big investments in a single type of asset. When crisis strikes or unperceived market events cause some industries to decline, investors with broad portfolios are better prepared for damage control.
Furthermore, factor analysis advances all kinds of quantitative strategies as it provides additional data and insights. Thus, even if factor investing is not the final goal, knowing how the stock measures against key risk factors are valuable information for the investors.
Adding this to the broader research or computer model may increase their accuracy and lead to unexpected insights that can be used for future decision-making.
Therefore, factor analysis can help any mindful investor and data-driven financial firm to achieve their investment goals and decrease the risks. Taking notice of the factors that make some stocks riskier and others promising is what allows investors to stay on top of their game.