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Fama–French Three Factor Model

Proponents of market efficiency divide risk into unsystematic and systematic. Unsystematic risk is not priced by everyone investing in the stock market. Here is an example to help you understand unsystematic risk. If you are considering investing in the stock market you could either buy specific stock in a specific company that you think will have a rise in price in the future. On the other hand if you don’t trust your stock ability you have the alternative of buying a basket of stocks that mimics the stock markets total combined movement. One way would to be to buy an indexed mutual fund like VFINX which is pegged to the S&P 500 which is a very large stock market index. The degree to which the stock moves relative to the general market is the unsystematic risk of the stock.

Systematic risk is the degree to which the stock changes in price relative to the general stock market as measured by an index like the S&P 500. Model calls this measure a stocks “beta.” The Fama-French Three Factor Model is a regression analysis that tries to separate out the systematic risk of a stock from the unsystematic risk by compensating for three factors. The first factor is a financial ratio called book to market. The second factor is the size of the firm as measured by its market capitalization. The third factor is the return on the market portfolio.

The book to market ratio is nothing more than what accountants estimate the company to by worth divided by the market capitalization of the company. The market capitalization of the company is the share price of the stock times the total number of shares the company has outstanding in the stock market. The return on the market portfolio is measured by some index like the S&P 500.

According to the efficient market school (which I do not agree with), size and book to market reflect systematic risk, meaning risk that requires compensation in the form of higher expected returns. If this is the case researchers should see that investors perceive small-value stocks to be riskier than large-growth stocks. The do see this which does lend some support to market efficiency. But investors consistently expect large-value stocks to outperform small-growth stocks and this is perverse. Basically, investors recognize that small upcoming companies are riskier but do not expect to be compensated for this risk as the efficient market model says that they should.

In a similar fashion, analysts tend to recommend growth stocks more favorably than they do value stocks. In the efficient market model of which the capital asset model (CAPM) is a part of, the profit from stock investing that investors expect should be as much as the risk they perceive that they are taking instead of the exact opposite which we find to be the case when actual research is performed on the matter.

This result caused the death of CAPM beta that was treasured by efficient market theorists despite the fact that the model resulted in the awarding of a Nobel Prize in economics to William Sharpe of Stanford University. Hirsh Shefrin has suggested that a behavioral beta be introduced into the model that might help explain these results that are contrary to market efficiency.

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07. Jan, 2011
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Stock Market Investing Tips

Use these stock picking tips to select the best markets, sectors and industry groups while investing in stocks. Stock picking done right is the first step in any winning stock trading system. After that comes the other step. So, you need to take your first step well if you want to do well with the later steps.

So what is a sector? A sector is a broad group of industries in an economy. For example, finance is one sector of the economy that might include banks, investment banks, pension funds, mutual funds and so on. Transportation can be another sector of the economy and it can include the airlines, railways, trucking services and so on. Consumer goods and services can be another sector of the economy. What is an industry group? An industry group is a smaller more specific grouping of companies in a sector. A subgroup will be even a more specific subcategory of companies in an industry group. Confused? Let’s make it clear with an example. Viacom is a well known name. Viacom is film, TV and radio company.So the sector of Viacom is Entertainment and Leisure industry. Within that industry the group is Media and within that group, the subgroup is TV/Radio.

Majority of the leading stocks are usually in the leading sectors. Research and study over many years has shown that 37% of the stock price movement is tied to the performance of the industry group the stock is in. Another 12% is due to the strength in the overall sector. So, you can see almost half of the stock price movement is tied to the performance of the industry group. Now, we all know specific groups lead in each market cycle, so you can see the importance of considering a stock’s industry before making the purchase.

There are something like 200 industry groups in US economy. Stocks in the same sector do not behave in an indentical manner. So, if a sector is outperforming the market, there will be groups and subgroups that will be outperforming in that sector while there will be groups and subgroups that might be showing weak performance in the sector. Looking at the S&P 500 index does not give you any clue about the performance of the different sector, industries and sub groups in the market. S&P 500 only shows the combined performance of 500 stocks that are included in it.

So if you are finally able to drill down to the best performing industry group and then to the sub-groups in the market, you can now pick those stocks that will show superior results as compared to average results by most of the stocks in the market. These stocks are going to give your portfolio above average performance than the market index. You will need to learn the different industry groups. I give you an example. Let’s take the medical industry in the economy. It is a huge sector of the economy. Now this sector can be further divided into indusry groups. Hospital companies, home nursing, generic drug companies, genetics, dental, HMOs, biotech and so on are some of the groups within the broader medical industry.

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06. Aug, 2010