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Step 8: Riskese

Implications Of The Five-Factor Model A summary of the average annual returns for all five risk factors is presented in Figure 8-12. Both the risk and average annual returns for all five risk factors are shown in Figure 8-13. The research of Eugene Fama and Kenneth French serves as a guiding protocol for both individual and institutional investing. Their Five-Factor Model has revolutionized how portfolios are constructed and analyzed, and was one of the primary reasons for Eugene Fama being awarded the 2013 Nobel Prize in Economics. As you have learned, three of the five factors apply to equities. The Three-Factor Model is an invaluable tool for asset allocation and portfolio analysis. In his own words, Eugene Fama explains the small-value story, among other subjects, in a November 2007 interview with The Region, a publication for the Federal Reserve Bank of Minneapolis. “So, small-cap stocks have higher average returns than large-cap stocks, and stocks with higher ratios of book value to market value have higher returns than low bookto-market stocks.” He continues, “Low book-to-market stocks tend to be growth stocks. High book-to-market stocks tend to be relatively more distressed; they’re what people call value stocks. That’s given rise to what the finance profession — academic as well as applied — calls the size premium and the value premium. The value premium tends to be bigger,” he said. “So, our model has three factors. Every asset pricing model says you need the market in there. Then they differ on how many other things you need. The CAPM says you only need the market. We basically say a minimum of two other factors seem to be necessary. And these two do a pretty good job.”87

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