It’s important to diversify your portfolio to hedge against risk. The traditional school of thought suggests that investors focus on things like asset allocation or striking a balance between stocks and bonds. But factor investing takes a different approach. This concept has gained popularity in recent years. If you’re not familiar with it, here’s a quick guide to the basics.
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How Factor Investing Works
Factor investing allows you to diversify your portfolio by looking beyond individual asset classes. So instead of simply buying up different kinds of securities, you would choose assets within the same group that vary in size, style and risk level. For example, you might compare large-cap stocks against small-cap stocks.
The idea behind factor investing is that when you group assets together based on factors outside of asset class, you can streamline your portfolio by selecting securities that don’t move in the same direction. Specifically, the emphasis is on producing results that are risk-adjusted so you get the same or better returns on your investments while minimizing the potential for losses.
What Are the Benefits?
The primary advantage of implementing a factor-based strategy with your investments is that it makes it easier to ride out market fluctuations. When you’ve got the right mix of high- and low-risk assets, movements in the market have less of an impact on your bottom line. When your portfolio is more secure, you end up with a more consistent stream of returns.
Another advantage of factor investing is that it can sometimes be more cost-effective than an approach based solely on combining asset classes. Once you tailor your investments and weigh them against similar securities, it’ll be easier to root out the assets that carry the highest fees.
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Watch out for Potential Pitfalls
Factor investing isn’t an exact science and there are a lot of elements that have to come together to make this strategy a success. Some of these elements are difficult to control, so you’re taking a gamble with factor investing.
Because it’s impossible to dictate what the market will do, even the most carefully crafted portfolio might not yield the returns you’re looking for if the conditions aren’t right. In a bear market, for example, factor-based portfolios aren’t completely insulated so your investments could fall short of your expectations.
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One other thing to consider is timing. Factor investing is often incorporated into a long-term plan. You can use it to cash in on some gains in the short run, as long as you’re aware that you might not be happy with the results.
Factor investing can be well-suited for investors who have time on their hands and who are looking to keep up with the market rather than surpass it. If you’re hoping to get rich quick, you might be better off using a different investment strategy.
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