Factor investing is a strategy in which the investor buys assets based on their underlying risk factors. The factors are broad economic factors that affect the economy and can affect a country, region, or even the world. When used as an investment strategy, factor investing can boost a portfolio’s returns, decrease risk, and reduce portfolio volatility.
Factor investing is often used in combination with other investing strategies. For example, some investors focus on low volatility and other factors such as quality and momentum. While investing in quality stocks can be profitable, sometimes they fall out of favor. If this is the case, an investor may want to diversify by reducing their exposure to quality stocks.
Factor investing relies on logic to choose stocks and asset classes based on underlying characteristics. It helps investors avoid the bias associated with human emotions. It helps investors diversify portfolios more efficiently and generate better returns than the market. Because it is based on empirical data, factor investing is an excellent complement to other investment strategies. Moreover, it minimizes the negative effects of emotion, while helping investors to better manage risk.
Another positive aspect of factor investing is that it is easy and affordable to implement. But investors should remember that factor indexes do not replace active management. They cannot replicate the value-added activities of active managers. However, they do offer an entirely transparent way to passively invest in factors, which can reduce the risk of manager style drift and enhance risk management.