Before going further into the article, let me give you a brief idea about Portfolio Management. Portfolio management consists of all the programs and projects that are prioritized by business objectives. Priorities are set through an appropriate value optimization process for the organization. Risk and reward are balanced and considered, and the programs are selected based on their alignment with organizational strategy.
The three-factor model, also known as the Fama and French three-factor model, and was developed in 1993 by Eugene Fama and Kenneth French. This three-factor model is widely canvassed by fund managers and investors to analyze and return consociated market/instruments to make the highest return for the risk taken.
CAPM (Capability Asset Pricing Model) model is the original model of the three-factor model. Hence, it is necessary to understand this model, for a great understanding of the three-factor model. The formula of CAPM is: R= Rf+ beta * (Rm -Rf), where R is the return, Rf is the return rate of risk-free investments, beta is the risk associated with a security market, and Rm is the return rate expected from the market. CAPM model successfully explains around 80% of returns.
The formula of three-factor model is: R= Rf + beta* (Rm-Rf) + Bs*SMB+ Bv* HML.SMB is called as the Small Minus Gap, and HML is known as "High Minus Low". Bs and Bv are beta corresponding to small cap and large cap portfolios having values of either 0 or 1.
The idea behind this model is that, value and small cap stocks often outperform large- cap stocks. The possible reasons for this could be a higher reward for compensating higher risk taken and early mispricing of equities. Basically small-cap companies often show better growth and this is reflected on their stock prices.
This model has gained lot of popularity amongst fund managers and investors because it has outperformed most others.So, if you want to have better understanding of market and its' gimmicks, follow the three-factor model.
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