Appendix A. Effective Diversification in a Three-Factor World

In their June 1992 Journal of Finance article, "The Cross-Section of Expected Stock Returns," professors Eugene F. Fama and Kenneth R. French revolutionized the way many individuals think about investing. Prior to the study, the prevailing theory (known as the "capital asset pricing model" or CAPM) was that the risk and return of a portfolio was largely determined by one factor: its beta. Beta is a measure of equity-type risk (or market risk) of a stock, mutual fund, or portfolio, relative to the risk of the overall U.S. stock market. An asset with a beta greater than one has more equity-type risk than the overall market; one with a beta less than one has less equity-type risk than the overall market.

The authors demonstrated we actually live in a three-factor world. The risk and return of a portfolio is also explained by its exposure to two other risk factors: size and price. Fama and French hypothesized that while small-cap and value stocks have higher beta—more equity-type risk—they also have additional risk unrelated to beta. Thus, small-cap and value stocks are riskier than large-cap and growth stocks, explaining their higher historical returns and implying such stocks should have higher expected returns in the future. Studies have confirmed that the three-factor model explains an overwhelming majority of the returns of diversified portfolios.

Using the Fama-French data series for the period 1927–2008, the average ...

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