Empowering Every Investor: How Factor Analysis Can Supercharge Your Portfolio

Six hours and fifteen minutes of trading every day—An infinitesimal amount of time, and yet it has the power to be the cradle of dreams. The parquet floor, every day, witnesses celebrations, heartbreaks, hopes and prayers.—everything at once—because it is the ladder par excellence for climbing fortunes.

With the eternal hope of making a fortune, millions of people in India have taken to trading, with an unprecedented recent surge. Demat accounts in the country have grown from a meager 36 million in 2020 to 160 million this year. 4.3 million of them only in June.

Apart from seeking substantial returns, of course, what is it that each of these traders yearns for? A little stability and a little impunity in the face of the factors that occasionally throw markets out of control, isn’t that right?

Where does stability and impunity come from? Investors around the world place their trust in “Factor analysis”, which we have already explained in great detail in the first two episodes of the explanatory video series, entitled ‘Beyond graphs and fundamentals: decoding factor analysis’.

In this way, we have taken the guesswork out of stock selection from the equation thanks to the insights provided by factor analysis.

Now it is time to come up with a viable strategy and put the theory of factor analysis into practice, or more precisely, to “build an investment portfolio using factor analysis.” Factor analysis helps us with stock selection, but the truth is that picking individual stocks carries high risks. What then creates sustainable wealth? Building a portfolio, which takes care of diversification!

Watch the third episode here:

Building a solid investment portfolio
A portfolio is a group of stocks that we choose, across different sectors and market capitalization categories, that complement each other in certain ways and ensure that we, as investors, get sustained returns on our investment. Portfolio building is a superset of stock picking.

To make things easier to understand, we have put together two sets of imaginary portfolios of ten stocks, with real stocks. Take a look at the first one.

This portfolio looks good, doesn’t it? A well-diversified portfolio made up of selected stocks from different sectors and market capitalization categories. The stocks are blue-chip and well-known among investors.

We will therefore expect the portfolio to deliver returns, as it should. However, contrary to popular perception, this approach may not be ideal as it could carry hidden risks or veiled threats that we often overlook.

Take a closer look at the table again. All of the stocks we selected have a high quality score, but they do not meet the requirements on other factors, including the momentum factor, the value factor, and the volatility factor.

What if the quality factor starts underperforming? We’ve seen that happen during the pandemic, it’s not a hypothetical situation. Quality stocks start underperforming and the quality factor falls out of favor, just like that.

What happens to our portfolio in such a scenario? It crashes, right? And that is too big a risk for any investor. All factors are important and unless we take them all into account, we will not be building a resilient portfolio.

A portfolio can be expansive with a large number of stocks, selected from different sectors, but ignoring risk factor exposure will eventually lead to undesirable results and/or losses.

How can we mitigate the risk? And the best part is that it’s not rocket science: it’s simply a matter of putting our knowledge of factor analysis into practice.

Check out this second portfolio!

At first glance, this second portfolio will look quite similar to the first, as it also has a great mix of mid-cap, small-cap and large-cap stocks across all sectors.

What sets this company apart? The fact that all stocks score above average on all factors. The momentum factor is excellent, the value factor is good, and the volatility factor is also profitable.

This portfolio ensures that it will weather any storm at any time. If one factor starts to lose its favor, other factors will come into play and save us from substantial losses, giving us the appearance of a certain stability that the investor craves.

Not only stability, the portfolio will give us the desired returns regardless of market conditions.

This is a solid mechanism that has been put in place after years of research and data analysis. The best investment managers in the world use this strategy to minimize losses and achieve consistency for their clients. Billions are invested every day betting on these strategies.

In India, Share.Market is the first and only discount broker that has democratized this technology and made it accessible to the masses at the retail level.

Start your factor investing journey today.

For more information, please visit the website.

Disclaimer:
This article is part of a series of three explanatory videos by Vaibhav Jain, Head of Content and Education at Share.Market. All opinions expressed in this article are those of the author.