Bottom-Up Works Best With Multiple Factors
CAPM was the first formal asset pricing model. Market beta was its sole factor. With the 1992 publication of their paper, “The Cross-Section of Expected Stock Returns,” Eugene Fama and Kenneth French introduced a new-and-improved three-factor model, adding size and value to market beta as factors that not only provided premiums, but helped further explain the differences in returns of diversified portfolios.
But financial innovation didn’t end there. Today the literature contains more than 600 investment factors, a number so great that John Cochrane called it a “zoo of factors.” However, as my co-author Andrew Berkin and I explain in our recently released book, “Your Complete Guide to Factor-Based Investing,” only a small number of exhibits within this factor zoo are required to explain almost all the differences in returns between diversified portfolios.
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