Dimensions of Risk Exposure

In 1992, Eugene Fama and Kenneth French introduced their Fama/French Three-Factor Model, identifying Market, Size and Value as the three factors that explain as much as 97% of the returns of diversified portfolios. Their data shows that small and value companies have carried higher risk and that risk has been rewarded. More than 85 years of risk and return data have confirmed their results.

Fama and French later expanded their model to explain fixed income returns, identifying Term and Default as two additional risk factors.

The Dimensions of Stock Returns: Market, Size, and Value

Market Factor:

The Market Factor is the amount of an investor's exposure to the overall stock market. Exposure to this factor is determined by the percentage of a portfolio that is invested in stocks as opposed to U.S. Treasury Bills, which are widely considered to be "risk-free" investments. The greater this exposure, the higher the expected return.

Size Factor:

Exposure to the Size Factor is determined by the percent of a portfolio that is invested in small company stocks. The greater this exposure, the higher the expected return in comparison to large company stocks.

Value Factor:

The Value Factor is the amount of exposure to low priced stocks, which is measured by a book-to-market (BtM) value ratio. When a stock's market price is less than its book value, the BtM ratio is greater than one. The greater the exposure to the value factor, the higher the historic and expected return in comparison to low BtM stocks.

The Dimensions of Bond Returns: Term and Default Risk:

Bonds are a component of investment portfolios because they dampen the volatility of stocks due to their low correlations to movements of stock prices. Bonds also provide short-term liquidity to investors with cash needs over a two to five-year period.

Term Factor:

The term factor is measured by the difference between the returns of long-term U.S. Government bonds (20+ years) and short-term U.S Treasury Bills. While the term provides higher expected returns, the excess returns diminish significantly beyond a term of five years, so bonds with terms of more than five years should be avoided.

Default Factor:

The default factor is associated with the credit quality of bonds. Instruments of lower credit quality are riskier than those of higher credit quality, thus yielding higher expected returns.

Long-term investment data makes it clear that value stocks outperform growth stocks and small company stocks outperform large company stocks, as seen in the U.S and Non-U.S. returns data in the bar chart below.