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Shrinking The Gap, Part 3- Risk Factors

J. Patrick Collins Jr., CFP®, EA

As we continue in our series on "Shrinking The Gap", we are going to focus on another positive contributor to performance:  exposure to risk factors.  Extensive research has been performed to determine what specific factors have a meaningful impact on both risk and return.  For purposes of this post, we are going to focus on the two that we believe are the most persistent:

  1. Size factor-  small companies outperform large companies
  2. Value factor- value companies outperform growth companies

In 1992, Nobel prize winner Gene Fama and Ken French release groundbreaking research on this topic.  Their findings were significant and have sparked an entire industry of "factor investing" or "smart beta" strategies.  The firm best embracing this concept (and finding the most success) has been Dimensional Fund Advisors.  A chart of the Fama/French research can be found below:

Risk factors

What their research has proved is that small companies and value companies have generated BOTH higher returns and higher risk for investors.  This is true not only in the US, but in other free market economies they were able to obtain data from.  So what does this mean for investors?  First, those who are willing to accept elevated risk levels are able to generate higher returns by tilting their portfolios towards these factors.  This is one way an investor can "close the gap" between their actual return and the market's return.  Second, rather than focusing things that don't matter (which fund is going to outperform, is the market high, which stock should I buy), investors now can concentrate their efforts on factors that will have a real impact on their portfolio's performance.