Three-Factor Model

The final component of Free Market Portfolio Theory is the Three-Factor Model, which defines three independent dimensions of equity returns. There are three independent dimensions of equity returns. It is possible to apply these factors to measure the role of each factor in returns.

The 3 Factors are:

  1. The Market Factor: the extra risk of Stocks vs. Fixed Income.
  2. The Size Effect: the extra risk of Small-Cap stocks over Large-Cap stocks.
  3. The “Value” Effect: the extra risk of high Book-to-Market (BtM) over low BtM stocks.

Investing is uncertain. Research hasn’t fully resolved the nature of risk and price movements. Until recently, much of investing involved guessing what really matters in returns. In 1991 this changed. Eugene F. Fama and Kenneth R. French, two leading economists, conducted an exhaustive investigation into the sources of risk and return. Grounded in Efficient Market Hypothesis (EMH), their research revealed that a portfolio’s exposure to three simple but diverse risk factors determines the vast majority of investment results. These three factors are referred to as the Three-Factor Model.

Pathfinder Wealth Management utilizes the Three-Factor Model when engineering portfolios to determine how many equity positions to hold, the allocation between small and large equities and the allocation between value and growth equities in each of the Pathfinder seven investment models. When properly educated, investors have the opportunity to apply these factors to their portfolio productively.