I’ve been preparing to actually use real world examples instead of just using readings and hypothetical portfolios used in course work. I may even use my own money depending on how much I actually have come when I’m prepared to start investing. I thought it would be important to catch up, reread, and read new things about Fama French and portfolio theory. Everyone always hears in investing to “diversify” what does that exactly mean and why is important. Well originally it meant just that to diversify your investments. Invest in real estate, stocks, bonds, options, futures, different industries…etc and this will lower your risk. If one of your investments performs poorly it doesn’t mean your whole portfolio will. Then Markowitz modern portfolio theory comes about which says that diversification does matter but what really matters is correlation and the level of risk one investment brings to the portfolio as a whole. You can have a 3% positions in a very speculative company and when you adjust for the level of volatility or risk it has you might find it adds substantial risk to your portfolio compared to other investments that hold +5% of your portfolio. Modern portfolio theory allows you to construct a portfolio with the greatest return and least amount of risk based off your level of risk aversion. Much like how many robo-advisors I’ve found do. They act like a large spreadsheet that you plug your inputs into. Finally we have our Fama French factors which include not only the CAPM excess return but Small Cap – Large Cap and Value and Growth stocks. Currently even more factors are being found that a portfolio can have exposure to, one I plan on talking about in both my AP and RA is mean reversion.
So what does having a diverse portfolio mean and how am I going to stay market and factor neutral? Well as an individual investor it means I won’t hold more than 5% of my funds in a single position. This ensures that if I am 100% invested that I at least get the diversification from owning 20 different securities. I’m going to be completely invested in only stocks and options though which will bring on more risk. Some of the risk can be alleviated by remaining both market and diverse among factors. So how do I stay market neutral? By operating like a hedge fund. So if I were 100% invested in 20 stocks each stock having a 5% position I would try to have 10 of my stocks as shorts and 10 as longs. That way when the market goes up my longs outperform and when the market goes down my shorts outperform. How do I stay factor diverse? Simple my investments have to have little factor exposure. For example of my 20 stocks 2 have significant large cap exposure, 3 small cap, 2 value, 3 growth, 5 high beta, another 5 low beta. It becomes quite complicated trying to diversify factors. Which is why much of the reading I have focused on is Fama French. The example above is a pretty poor example of being diverse, hopefully the stocks I pick will already have little factor exposure. Even more so complicated when the fact that there are other factors out there that I can become exposed to such as mean reversion.
Example of how Fama French Factors are calculated. Will do my own video soon as part of my AP.