Multifactor Models and Modern Portfolio Theory

"There are more things in heaven and earth, Horatio, than are dreamt of in your philosophy," goes a line from Hamlet. Perhaps Horatio used the capital asset pricing model (CAPM).

There is more. Empirical evidence suggests this. A single-factor model predominantly uses market risk in some form, but investors don't predominantly use a single-factor model. __Multifactor models__ are more popular now, as they are observed to perform better. A "factor" is some variable that's correlated with asset returns. What is an example?

No. Constants don't correlate with anything; only variables do. But the price-to-earnings ratio is a good example.

Yes.

A lower P/E ratio tends to be correlated with higher returns, just like a small firm size, momentum factors, etc. So multifactor models reach out to these explanatory variables for greater predictive power than what beta alone can offer.

Going back to Markowitz in 1952, modern portfolio theory suggests that any asset can be part of a portfolio, so it's really your fault if you don't diversify. Don't expect that the total risk will be compensated. The only risk that deserves compensation is systematic risk. That's where the CAPM comes in with its single factor of beta to measure market risk. But what would you have to conclude after observing the P/E and return correlation?

No. That's too harsh to say about poor beta. It has provided decades of information.

Not really. It doesn't hide risk; it just doesn't explain it all.

That's right. Beta isn't bad or wrong, just incomplete. If you can get a better estimate by adding more factors, it's hard to argue why you shouldn't add more factors. There are limits, of course, but at least start with some value measure like the P/E ratio. Hamlet might be suggesting that ratio to Horatio.

To summarize: [[summary]]

Do you suppose these factors will have equal or unequal effects on asset returns?

Probably not. That would be an amazing coincidence.

Of course.

Market risk might still get most of the credit in explaining returns. Some factors are minor. Still, it's information.

A constant, such as 1.5

The price-to-earnings ratio

Beta is incomplete

Beta tends to hide actual risk

Beta doesn't provide any information

Equal

Unequal

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