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The Three Factor Model of the Stock Market: The Fama-French

Article:

Proponents of market efficiency divide risk into unsystematic

and systematic. Unsystematic risk is not priced by everyone

investing in the stock market. Here is an example to help you

understand unsystematic risk. If you are considering investing

in the stock market you could either buy specific stock in a

specific company that you think will have a rise in price in the

future. On the other hand if you don't trust your stock ability

you have the alternative of buying a basket of stocks that

mimics the stock markets total combined movement. One way would

to be to buy an indexed mutual fund like VFINX which is pegged

to the S&P 500 which is a very large stock market index. The

degree to which the stock moves relative to the general market

is the unsystematic risk of the stock.

Systematic risk is the degree to which the stock changes in

price relative to the general stock market as measured by an

index like the S&P 500. Model calls this measure a stocks

"beta." The Fama-French Three Factor Model is a regression

analysis that tries to separate out the systematic risk of a

stock from the unsystematic risk by compensating for three

factors. The first factor is a financial ratio called book to

market. The second factor is the size of the firm as measured by

its market capitalization. The third factor is the return on the

market portfolio.

The book to market ratio is nothing more than what accountants

estimate the company to by worth divided by the market

capitalization of the company. The market capitalization of the

company is the share price of the stock times the total number

of shares the company has outstanding in the stock market. The

return on the market portfolio is measured by some index like

the S&P 500.

According to the efficient market school (which I do not agree

with), size and book to market reflect systematic risk, meaning

risk that requires compensation in the form of higher expected

returns. If this is the case researchers should see that

investors perceive small-value stocks to be riskier than

large-growth stocks. The do see this which does lend some

support to market efficiency. But investors consistently expect

large-value stocks to outperform small-growth stocks and this is

perverse. Basically, investors recognize that small upcoming

companies are riskier but do not expect to be compensated for

this risk as the efficient market model says that they should.

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In a similar fashion, analysts tend to recommend growth stocks

more favorably than they do value stocks. In the efficient

market model of which the capital asset model (CAPM) is a part

of, the profit from stock investing that investors expect should

be as much as the risk they perceive that they are taking

instead of the exact opposite which we find to be the case when

actual research is performed on the matter.

This result caused the death of CAPM beta that was treasured by

efficient market theorists despite the fact that the model

resulted in the awarding of a Nobel Prize in economics to

William Sharpe of Stanford University. Hirsh Shefrin has

suggested that a behavioral beta be introduced into the model

that might help explain these results that are contrary to

market efficiency.

About the author:

Dr. Brown can teach you how to invest through The Delano Max

Wealth Institute (www.DelanoMax.com). He is dedicated to

providing you with courses and seminars that teach prudent

savings and investing habits. Dr. Brown is also a finance

professor at the University of Puerto Rico at Rio Piedras. He is

also recognized as an expert at low risk, high return investing

and takes great pride in helping others retire safely.