Factor Investing: Using Value, Momentum, and Other Factors

Introduction: What Is Factor Investing?

Factor investing is one of the most important—and misunderstood—ideas in modern investing. It’s a way to use proven, research-backed characteristics (“factors”) to build a portfolio that targets better returns or lower risk.

Instead of picking individual stocks based on stories or hunches, factor investors follow rules to select groups of stocks with certain features—like low price, high momentum, or strong profitability. These factors have been shown, over decades of academic research and real-world investing, to beat the market on average over time.

In this guide, you’ll learn:

• What factor investing really means (and why it works)

• The most popular factors: value, momentum, quality, low volatility, and size

• How factor-based strategies and smart beta ETFs work for everyday investors

• Common pitfalls, risks, and how to use factors wisely in your own portfolio

1. The Basics: What Is a “Factor” in Investing?

A factor is a stock characteristic or attribute linked to higher returns, lower risk, or both.

Classic factors include:

• Value: Stocks that are cheap relative to earnings, assets, or dividends.

• Momentum: Stocks with strong recent price performance.

• Quality: Stocks with strong balance sheets, stable earnings, or high profitability.

• Low Volatility: Stocks with less dramatic price swings.

• Size: Smaller companies (small caps) often outperform larger ones over long periods.

Why factors matter: Academic studies—starting with the famous Fama-French models—show that certain factors have historically beaten the overall market, often with less risk.

2. Why Factor Investing Works: The Science and the Psychology

Factor investing isn’t a new gimmick. It’s built on decades of research into what actually drives returns.

Two big reasons it works:

1. Market Inefficiency: Not all stocks are priced perfectly. Investors overreact to news, chase fads, or avoid “boring” value stocks—creating opportunities.

2. Behavioral Biases: Human nature leads to crowd behavior, panic selling, and trend chasing. Factor strategies exploit these persistent errors.

Example:

• Value stocks (cheap, out-of-favor) often rebound as perceptions change.

• Momentum stocks (recent winners) keep rising as more investors pile in.

3. The Most Popular Investing Factors

a. Value Factor

• Looks for stocks trading at low prices compared to earnings (P/E), book value (P/B), or dividends.

• Famous investors like Benjamin Graham and Warren Buffett started as value investors.

• Why it works: Investors often avoid stocks with bad recent news, creating bargains.

b. Momentum Factor

• Buys stocks with strong recent performance (e.g., top 12-month returns).

• Based on the idea that “winners keep winning”—at least for a while.

• Why it works: Investors tend to follow trends and chase past performance.

c. Quality Factor

• Focuses on companies with strong balance sheets, high return on equity, and stable profits.

• Why it works: Quality stocks hold up better in downturns and compound wealth steadily.

d. Low Volatility Factor

• Targets stocks with the lowest price swings.

• Surprisingly, low-volatility stocks often outperform riskier ones—contradicting classic “risk equals reward” thinking.

e. Size Factor (Small Cap Premium)

• Invests in smaller companies, which historically grow faster than giants.

• Why it works: Smaller firms are riskier, less researched, and have more room to expand.

4. How Factor-Based Strategies and Smart Beta ETFs Work

Factor investing used to be the domain of academics and Wall Street pros—but now anyone can use it.

How it works:

• Instead of buying a basic index (like the S&P 500), you can buy “smart beta” ETFs or funds that track stocks with specific factors.

• Examples:

  • Value ETFs (select stocks with low P/E or P/B)

  • Momentum ETFs (own recent top performers)

  • Quality or low-volatility ETFs (screen for certain financial ratios or stability)

Why use smart beta?

• Lower fees than active funds; more transparent than stock picking.

• Offers a rules-based way to target proven return drivers.

5. Real-World Performance: Do Factors Really Outperform?

Decades of data show that factor investing can beat the market—but not every year, and not every factor at the same time.

• Value and small cap outperformed most decades, but lagged during tech bubbles or market manias.

• Momentum shines during strong trends but can suffer in choppy or volatile markets.

• Low volatility and quality often outperform in bear markets or recessions.

Important: Factors have cycles. What works in one year might underperform in the next. That’s why many pros combine several factors (“multi-factor”) to smooth out the ride.

6. Risks and Common Mistakes in Factor Investing

a. Chasing Past Performance

• Don’t just buy last year’s winning factor. Mean reversion is real—hot streaks fade.

b. Overconcentration in One Factor

• Relying on a single factor can leave you exposed to long cycles of underperformance.

c. Not Understanding What’s Under the Hood

• Smart beta ETFs aren’t all created equal—some use different screens or rules, which can lead to surprises.

d. Ignoring Costs and Turnover

• Frequent rebalancing or high fees can eat into returns.

e. Timing the Market with Factors

• It’s tempting to “switch” between value, momentum, or quality—resist the urge. Consistency is key.

7. How to Build a Multi-Factor Portfolio

The best investors rarely rely on just one factor. Instead, they combine several—balancing strengths and weaknesses for a smoother ride and more consistent performance. Here’s how to do it:

a. Combine Complementary Factors

• Value + Momentum: Value stocks are cheap, but can stay cheap a long time; momentum ensures you ride trends, catching stocks already moving upward.

• Quality + Low Volatility: Quality stocks tend to weather downturns; low-volatility picks reduce big swings, adding comfort during rough markets.

• Size + Value/Quality: Small caps offer growth; pairing them with value or quality screens helps avoid the riskiest “story stocks.”

b. Use Multi-Factor ETFs

Many asset managers offer ETFs that blend factors, like “value + momentum” or “quality + low volatility.” Examples include iShares Edge MSCI Multifactor ETFs or similar options from Vanguard and Invesco.

c. DIY Multi-Factor Portfolio

• Pick 2–4 core factors that fit your style and risk tolerance.

• Allocate part of your portfolio to each factor, using ETFs, mutual funds, or screened baskets of individual stocks.

• Rebalance every 6–12 months to maintain your chosen weights and avoid factor drift.

8. How to Choose the Right Factors for You

Not every factor suits every investor. Ask yourself:

• Are you patient? Value and small-cap factors can underperform for years before rebounding.

• Do you prefer stability? Low volatility and quality might be a better fit.

• Can you handle swings? Momentum can deliver sharp outperformance, but sometimes reverses quickly.

• Do you like hands-on research? DIY factor investing rewards those willing to learn about screening and portfolio maintenance.

Remember: the best factor mix is one you can stick with, even during tough cycles.

9. Risks, Drawdowns, and “Factor Winters”

No factor outperforms all the time.

• “Factor winter” refers to periods when a factor—like value, momentum, or size—lags the broad market for years.

• During the 2010s, value investing had a long cold streak as growth stocks soared.

• Momentum sometimes crashes hard when trends reverse.

Survival tips:

• Don’t give up after one rough year—most factor returns come in “spurts,” not smooth lines.

• Diversify across several factors to cushion the pain when one underperforms.

• Set expectations: factors are long-term bets, not get-rich-quick tools.

10. Common Myths and Mistakes in Factor Investing

a. “Factors Always Beat the Market”

Not true. Factors have advantages over decades, not every year. Don’t expect constant outperformance.

b. “Last Year’s Winning Factor Will Win Again”

Mean reversion is common. Yesterday’s top factor may lag in the next cycle.

c. Ignoring Costs, Turnover, and Taxes

Some factor funds trade frequently, creating taxable events and higher fees. Check each ETF or fund’s expense ratio and turnover.

d. Overcomplicating With Too Many Factors

Three or four factors are usually plenty—don’t chase every trend or get lost in “factor soup.”

e. Assuming All Smart Beta ETFs Are Created Equal

Look under the hood—different funds have different rules and can produce wildly different results.

11. FAQs: Factor Investing for Beginner

Q: Is factor investing passive or active? A: It’s “rules-based active.” Factors use systematic rules, but unlike plain index funds, they actively seek out certain stock traits for higher returns.

Q: How long should I stick with a factor strategy? A: Ideally, five years or more. Factor investing rewards patience and discipline.

Q: Are factor strategies riskier than index funds? A: Some are (like small-cap or momentum), while others (low volatility, quality) may actually reduce risk.

Q: Can I combine factor ETFs with regular index funds? A: Absolutely. Many investors use a core of broad index funds plus a “satellite” of factor-based ETFs for extra return potential.

Q: Do I need to understand all the math and research behind factors? A: No. Understanding the basic logic and risks is enough—let the ETFs or mutual funds handle the complex calculations.

12. Where to Learn More: Resources & Internal Links

Ready to harness the power of factor investing with confidence? See why StockEducation.com is the top choice for beginners and advanced learners:

• Step-by-step factor guides: Master value, momentum, quality, and more with plain-English lessons.

• Practical portfolio tips: Learn to build and rebalance your own multi-factor approach.

• Data-backed strategies: See which factors work best in which markets, and how to avoid classic pitfalls.

Start building smarter portfolios and beat the crowd, year after year—at StockEducation.com, the world’s most complete resource for modern investors.

13. Conclusion: Factor Investing for the Long Haul

Factor investing gives everyday investors a scientific edge—if you stay patient, disciplined, and realistic. Combining time-tested factors like value, momentum, and quality lets you stack the odds in your favor, even if each one has its “winter.”

The key?

• Don’t chase last year’s winner.

• Diversify across a few proven factors.

• Stick to your plan, no matter what headlines say.

Investing is a marathon, not a sprint—and factor investing is one of the best ways to keep running ahead of the pack.