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Sound Advice: July 27, 2022

Is investing by factor a good idea? 

Stocks can be described in many different ways, but common descriptions include labels such as Value, Quality, Momentum, Small Cap, Defensive, Cyclical, High Dividend, Minimum Volatility, and Multi-Factor.  It should come as no surprise that each of these has a strong following among different groups of investors.

Let’s deal with the definitions first.

Those in the Value group have low price-earnings ratios.  The Quality group leans toward the major companies that are the foundations of the U.S. economy.  Momentum stocks are those with above average price performance over the latest six and 12 months.  Small Cap stocks are those of smaller companies, which tend to grow more quickly, but are more susceptible to downturns in the economy.  Defensive stocks are those of companies whose products and services are essential (think Procter & Gamble).   

Cyclical stocks are those of companies whose progress tends to go through boom-and-bust periods.  High Dividend Yield stocks are those with well above average dividend yields.  Minimum Volatility stocks are the ones that fluctuate least during periods of market weakness and strength.  And Multi-Factor stocks are those that would qualify for more than one of these labels.

The factor that turned in the best performance over the last 15 years was Momentum, which ended up in first place five times with average annual returns of 11.8%, but as one might suspect, this group has been next to last for the first six months of this year.  What’s more, Momentum dropped from the top to the bottom three times in the years following its first-place finish.

Next best were Value stocks, coming in first place four times.  Here, too, the follow-up was problematic.  In 2013 and 2014, Value stocks led the pack.  Then in two of the next four years Value stocks were at the bottom.

Quality stocks were just behind with yearly returns of 11.5%, though they too were among the worst performers through midyear.  In most years, they were somewhere near the middle.

What was the best performing group this year? Defensive stocks, which lost only 3.2%, but that’s after four out of 15 years in which this group was the weakest performer. And in five other years, the returns from these stocks were well below average.

When trying to identify a group of stocks or funds with real advantages over time, it’s essential to concentrate on the consistency and rate of forward progress, financial health, and an economic environment that favors the goods and services they provide.

N. Russell Wayne, CFP®

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