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The Factor Difference

Today’s investors can take advantage of many advances in academic finance; including "factor" investing.  Factor investing involves overweighting (relative to the overall stock market) small cap and value stocks.  In 1992, Professors Eugene Fama and Kenneth French documented the historical return premiums (over the market return premium) of small cap and value stocks.  Last week’s article, Factor Investing, explained their Three-factor model in greater detail.

How can long-term, disciplined investors benefit?  The following case contrasts investing a 50% stock/50% bond portfolio using the Standard & Poors 500 index  versus a three-factor portfolio.  The main assumptions are:

  • The beginning value of the portfolio is $1M. 
  • A couple, both 65 at the start, take $40,000/year from the portfolio.
  • Each year the amount taken from the portfolio is increased by 3% to account for inflation.
  • The portfolio is 50% stocks/50% bonds and rebalanced annually.
  • The analysis runs for 30 years with 209 trial periods.
  • A successful outcome is for the couple means having money left in 30 years.
  • The first portfolio uses only the S&P 500 for its stock allocation.
  • The second portfolio uses a mix of large cap, large cap value, small cap and small cap value stocks in its stock allocation.
  • Only U.S. stocks are used in the portfolio.
  • The analysis tool was the Cashflow Fingerprint financial planning program (which is available to Vestory clients.

The Results

  • The first portfolio (S&P 500 only), ran out of money 4% of the time.  
  • The second portfolio (three-factor) did not run out of money.
  • The first portfolio had an average ending value of $1,833,523 (when it survived for 30 years).
  • The second portfolio had an average ending value of $3,655,396 (with a 100% survival rate after 30 years).
  • The results show that our hypothetical investors could have increased their net worth, sometimes by several million dollars, by using factor investing instead of just the S&P 500 for their stock allocation.

See the attached document for the complete details of the analysis.

Q&A: Stay in Bonds?

2014 Market Review from DFA