Value. Size. Momentum. Quality.

Most AAII members seek stocks possessing at least one of these four traits. Some may require more than just one. The preference can be related to a style of investing you associate yourself with. Some of you reading this may describe yourselves as value investors, for instance.

Within both academia and the investment industry, the four traits are known as factors. A factor is an anomaly. Factors explain why a stock’s return is different than what one would expect after adjusting for a stock’s volatility relative to the market (aka beta). In lay terms, factors are a quantitatively identifiable trait of a stock associated with long-term outperformance. In academia, a factor exists if a portfolio composed of stocks with strong exposure to a trait outperforms a portfolio composed of stocks with weak exposure to the trait, and the outperformance cannot be explained by beta alone.

There is a strong argument for making use of factors from the standpoint of building wealth. Investors can reasonably expect higher long-term returns by filling their portfolios with stocks possessing the traits of lower valuation, smaller market capitalization, stronger momentum or good quality. Furthermore, these long-term returns should be high enough to compensate for any additional volatility incurred.

The historical record shows this to be the case. Behavioral errors, professional portfolio managers’ inability to adhere to factor strategies and constraints faced by hedge funds and other trading firms suggest that the odds of factors continuing to be associated with long-term outperformance in the future remain good.

Jack Vogel of investment firm Alpha Architect and I did a bit of a deep dive into factors. In doing so, we also discussed how to use factors in an individual investor’s portfolio. It was a stimulating conversation; you can find it here.

As a group, individual investors do not tend to think in terms of factors. Many investors likely incorporate factors into their portfolio strategies without even realizing they are doing so. Small-cap investors have exposure to the size factor. Many dividend investors may have exposure to the quality factor—particularly those investors who favor more stable and profitable blue-chip dividend payers. (Dividends, themselves, are not a factor. Jack explained why during our conversation.)

One of the unsung advantages of factors is their ability to help you select stocks. If you have a preference for a certain style of investing, you can use it to narrow down your list of candidates. If you prefer outperforming stocks as opposed to bottom-fishing among stocks trading near their 52-week lows, you can use momentum measures to pare down your options.

This use of personal preferences when choosing stocks is part of the PRISM Wealth-Building Process. The process calls for using an investment strategy you can stick with. As is the case with preferring Coca-Cola or Pepsi, some of you may be value investors and others growth investors. There is research suggesting these preferences are set during birth and/or childhood. (See “Biology and Life Experiences Influence Investing Style” in the Dispatches section of the August 2015 AAII Journal.)

Because preferences and investing styles differ so much, I purposely excluded specific buy and sell rules for selecting stocks. There simply isn’t a one-size-fits-all strategy. I’ve talked to many investors over the years—both individual and professional—and have heard about more strategies than I could ever possibly keep track of. So what I did is develop guidelines and metrics anyone can use to create or modify their own rules. You can find them in my latest PRISM Wealth-Building Process article here.

Simplicity is always a very good starting point for creating buy and sell rules. Requiring, say, sales growth of at least 5% or a price-earnings (P/E) ratio below 18 will get you surprisingly far in terms of success compared to an investor who lacks any portfolio rules. A simple set of buy and sell rules that is routinely followed works extremely well.

Finally, I want to invite you to the AAII Investor Conference 360. For the first time ever, we will be hosting the conference virtually. You’ll be able to watch it live from anywhere there is an internet connection. Plus, attendees will have access to video recordings of any session they missed or want to see again.

The highlight, of course, will be the speakers. We’ve invited popular speakers from past conferences—Christine Benz, Paul Merriman and Sam Stovall, to name a few. We’ll also have some exciting new speakers, including personal finance expert Terry Savage and former Vanguard CEO Jack Brennan. Find out more here.

Wishing you prosperity,

Related

PRISM Wealth-Building Process

Guidelines for Selecting Stocks for Your Portfolio

Related

Feature

What Are Factors? A Look Behind the Curtain

Related

Dispatches

Biology and Life Experiences Influence Investing Style