What Are Investment Factors?
Investment factors are persistent, pervasive, and economically meaningful characteristics of securities that explain differences in expected returns. The Fama-French three-factor model (1993) extended the Capital Asset Pricing Model (CAPM) by showing that market beta alone doesn't explain expected returns — two additional factors improve explanatory power: size (SMB: Small Minus Big — small-cap stocks have historically outperformed large-cap) and value (HML: High Minus Low — stocks with high book-to-market ratios have outperformed those with low ratios). Since then, research has identified multiple additional factors with evidence of return premiums. A factor must be: (1) Persistent — works across long time periods. (2) Pervasive — works across multiple asset classes and geographies. (3) Robust — works with different metrics measuring the same underlying idea. (4) Investable — can be accessed after transaction costs. (5) Economically rational — has a plausible risk-based or behavioral explanation. The debate about why factors work: risk-based explanation (factor premium compensates for a systematic risk that hasn't been captured — investors demand a premium for bearing this risk) vs. behavioral explanation (factors exploit systematic cognitive errors by investors — e.g., value works because investors are consistently too pessimistic about beaten-down stocks). If factors work because of cognitive errors, they may be arbitraged away as more investors learn about them; if risk-based, the premium should persist.