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The One Factor to Explain Them All

(This post is a bit tongue-in-cheek so please don’t take it too seriously)….

Yesterday’s post on hedge funds got me thinking again about how vague “risk factors” are.  CAPM uses a one factor model showing that risk explained why certain assets performed better than others.¹ Basically, take more risk and you’ll generate a better return. That didn’t exactly explain things though. In fact, higher risk often correlates with worse returns.²

Over the course of the last 25 years the idea of “factor investing” has really boomed.  And investment companies loved this because they could market specific stylized facts that explained why the markets do certain things and why you should pay them high fees so they can take advantage of those things for you. Heck, even hardcore passive investors, who are notorious fee avoiders, will trip over themselves buying higher fee funds trying to guess the best factors to own at certain times.

As a result, we got the small cap factor and the value factor and the momentum factor and all sorts of other factors. I think we’re up to 1,000+ factors now. There are so many I could just start making them up.  And I will.  Right now. For instance, companies whose founders are dog owners might outperform companies whose founders are cat owners.  This is a perfectly logical assumption because dogs are better than cats so company founders who own dogs must be smarter than company founders who own cats.  So, we now have the dog vs cat factor.  If I tweak some data and find it’s statistically meaningful over long periods of time then I might even start a high fee fund to sell you. No cat owners allowed, obviously.

Okay, okay. I am being stupid. I know. But you see my point, right? A lot of these “factors” could be nothing more than slick data mining by someone who found a pattern that doesn’t really exist.  We want to understand and be able to predict things so badly that we often find stylized facts where they don’t even exist.  But maybe we just can’t know. That doesn’t mean it’s not worth trying to find out or to try guessing about future outcomes.  But we should start from one general factor:

The We-Know-A-Lot-Less-Than-We-Think-We-Know Factor

This doesn’t require some law of the financial markets that says anything has to outperform anything else over the long-term.  Yes, we know that stocks will generally beat bonds because they’re a contract that gives the equity owner greater claim to profits than the bonds, but that doesn’t mean stocks have to outperform bonds or even that they’re more risky (whatever “risk” means in the context of this discussion to begin with, but that’s a whole other matter). The point is, you don’t necessarily earn a “risk premia” in stocks. You earn a contractual premia assuming the firm earns enough profit to pay it out (good luck predicting which firms will generate the highest profits in the future) and a bunch of apes with keyboards try to guess what the future value of those profits will be.³

Importantly, no one needs the efficient market hypothesis to understand why markets are really hard to beat. You just need the basic arithmetic of global asset allocation to understand that.  This whole monetary system is something humans created from thin air. And we have, at best, an imprecise understanding of what financial assets are really worth at certain times and so the best we can do is try to understand the world for what it is, slap together some sound assumptions about the future, reduce our frictions, manage the known risks as best as possible and hope it doesn’t all fall apart at some point.  Is it really much more complex than that?

¹ – Here’s the Three Factor Model. Here’s the Five Factor Model.  Here’s a 100+ Factor model paper.  Here’s a real model.  

2 – See this paper titled “High idiosyncratic volatility and low returns: International and further U.S. evidence“.  

3 – This is not to imply that there is no such thing as an equity risk premium, but rather to point out that trying to calculate such a thing probably won’t help you become a better investor.