Recently, factor investing is the buzzword among investors of all sizes. If you are also already influenced by someone to implement factor investing, then this post will help you in understanding it better. So, let’s start by taking an example.
In the case of selecting a football team, players are not chosen solely based on their ability to control the ball. Instead, there are many other criteria such as sportsmanship, fitness level, agility, muscular endurance, cardiovascular endurance, the image of the player, etc., that come into play while selection. Similarly, a simple diversification of a portfolio based on assets is certainly not enough in the investment world.
When various investors realized this fact, it gave rise to one of the most emblematic transformations in investing strategy, i.e., ‘Factor Investing’.
In this post, you will understand how you can trade based on factor investing and what are the dos and don’ts that you need to keep in mind. But before we dive deep into this main thread, let’s first understand what exactly is factor investing.
What Is Factor Investing?
Factor investing is a unique investment style that targets certain drivers of higher returns. It utilizes specific factors, such as fundamental, statistical, or macroeconomics, to analyze the asset prices and create a cutting-edge investment strategy for the best possible outcomes.
What Is A Factor?
Factor investing embraces the idea that ‘factors are the building blocks of an effective investment portfolio’. In the world of investing, ‘factors’ can be defined as the attributes that can explain the risks as well as returns of an asset, thus they can assist you to outperform in the highly competitive market.
Types of Factors
When we talk about the types of factors, two major ones have driven maximum returns: macroeconomics and style factors. Economic growth, inflation, credit, emerging markets, liquidity, and real rates come under the category of macroeconomic factors; whereas value, momentum, low volatility, size, and quality are style factors.
How Can You Trade Based On Factor Investing?
The process of trading based on factor investing requires a simple framework that involves flexible and structured components. We’ll first know the basic steps of factor investing-based trading and then look at a few trading strategies that will keep you focused on the end goals.
The typical steps are:
- Determining A Trading Idea: In factor investing, successful trading requires a strong idea on the basis of great market insight and solid economic intuition. Therefore, the very first step is to define a trading idea on the basis of results-driven attributes. You can also carry out extensive research to grasp the knowledge of what other traders have done in the past. Your trading idea should consider the three most important aspects: minimum volatility, ability to outperform in the market, and high diversification. A well-established trading ideology will certainly drive you towards your goals.
- Developing Quality Factors: As mentioned earlier, factors are the building blocks of an investment strategy. When you are doing factor investing, developing the appropriate factors becomes a pivotal option for quality outputs. Therefore, make sure that the stocks have more stable earnings, higher returns, stronger balance sheets, and higher margins so that they can outperform in the trading world.
- Gaining & Analyzing Data: This third step is an evolutionary one that provides a deep insight into factor-based trading. After gaining appropriate data, you need to analyze it to enhance your trading strategies. Moreover, a proper analysis of data will certainly help you in designing risk-adjusted strategies. Therefore, your factor investing-based trading model should be based on the data for extensive positive results.
- Analyzing Factors: The next step is to analyze those factors which can deliver risk-adjusted returns. You can carry out the process of factor analysis by analyzing the stocks, funds, and strategies because they all will assist you in identifying which factors will provide you with a higher yield. In the trading realm, it becomes quite difficult to understand why a stock, fund, or strategy is performing worse than the others. That is when factor analysis becomes a pivotal step to pinpoint the source of returns.
- Building The Right Trading Strategy: There is an utmost need for having a clear vision of your financial goals while building an effective trading strategy based on factor investing. You should take into account your ability to tolerate risks, your short-term and long-term financial goals, and your awareness of how trading can add an extra edge to your investment portfolio. Always analyze all such factors and then determine the right strategy that can perform well.
- Evaluating The Trading Strategy: Sometimes, it may become important for you to alter your trading strategy. Of course, you will look at the ways to draw out maximum profits from your trade. Therefore, the next step is to evaluate the performance of your trading strategy intensively. You can do it in numerous ways such as you can do a proper accounting of costs (for example, commissions and slippages) or you can create certain metrics (for example, Sharpe ratio, Sortino ratio, annualized volatility, annualized returns, profitability, average profit/loss, and max drawdown).
- Backtesting The Trading Strategy: Suppose you have created a new trading strategy. It works for a while, but later on, you encounter lost trades. That is why backtesting a trading strategy is extremely important because it allows you to examine how well your strategy will work. You need to consider the following attributes for backtesting:
- Volatility measures
- Net profit or loss
- Exposure to the market
- Annualized return
- Risk-adjusted return
- Implementing The Trading Strategy: The last step is to push an entry trigger button. The implementation of a trading strategy involves:
- Selecting a market
- Selecting a time frame for your trade
- Determining the tools, and
- Entering the market while keeping in mind the trading ideology.
How To Trade Like A Pro?
- Firstly, identify the appropriate stocks and filter out the most volatile ones from them. It is because our primary aim should be low-volatility investing, which is one of the basic foundations of factor investing.
- Secondly, keep hold of only those stocks that earn positive scores on the 3 most important factors: momentum, quality, and value. This will help you to mitigate risks and boost up returns.
Two Effective Trading Strategies Based On Factor Investments
A well-designed strategy will certainly lead you to the path of success with extensive profitable results. Let’s discuss briefly the two most prominent and effective trading strategies that can transform the whole phiz of your trading world:
- Momentum Factor Trading Strategy: In factor investing, momentum means the ability to deliver higher returns while going forward in the future. A momentum factor trading strategy primarily aims at buying stocks that have been outperforming and selling underperforming stocks. One requires to develop considerable skills and effective marketing techniques while using this type of trading strategy.
- Beta Factor Trading Strategy: Beta is the measure of your correlation with the market returns. If the market falls down, then your portfolio will also be down. Similarly, if the market goes up, then your portfolio will also rise. Besides, this strategy will also help you in measuring stock returns in comparison to other asset classes.
Do’s & Don’ts
- Do a ton of research.
- Check charges.
- Diversify your investments.
- Take calculated risks.
- Master your skills before trading.
- Be aware of market rumors. Don’t fall for them.
- Do not go by any kind of promise by anyone else.
- Try to have a unique mentality. Do not follow the crowd.
- Don’t get excited about short gains.
- Don’t panic.
The Bottom Line
Undoubtedly, factor investing-based trading is a powerful tool for various investors. If you will understand deeply how to trade in the realm of factor investing, you will certainly block out the noise from market actions and will increase the chances of your success dramatically.
Want to harness it efficiently but don’t know how to do it? If so, you’ve reached the correct destination.
Wealthface is a credible financial advisor that helps businesses and individuals by making them financially stronger. It builds strong investment portfolios that reap high returns. With a team of professionals, we efficiently harness robust tools to know what makes the market fall and rise. And thus, we help you in mitigating the risk and in maximizing the profits.
If you want to know more about factor investing, visit wealthface today!