Since the vast majority of companies go bankrupt, your belief is that you would not outperform if you had a higher ability, on average, to exclude those companies? After all, it is much easier to determine potential bankruptcy, right?Predicting outperformance is significantly different than predicting bankruptcy, which is one reason why stock investing is so much riskier than bond investing.So stock pricing is some voodoo that can't be known? We can identify the relative risk of companies that issue corporate debt via fundamental metrics but we can't know the relative riskiness of the same companies that also issue equity?However, there are differences between stocks and bonds. It’s easier to judge which companies are in danger of bankruptcy and will default on their bonds, compared to predicting which companies will outperform others in terms of their stock performance.Stock factors are intended to be like duration and credit risk of bonds. The market applies a discount rate to bonds just like is does to stocks. Otherwise, why would anyone buy corporates if they did not have a pricing discount relative to treasuries? Rating agencies rate both sovereign and corporate bonds. Investopedia puts it as: "Rating agencies examine financial variables to determine the creditworthiness of a company. Financial statements, cash flow analysis, debt ratios, profitability measurements, and liquidity measures are a few examples of these indicators."
I can tilt my portfolio towards less risky bonds (treasuries, investment grade bonds) or if I want to take on more risk for potentially more reward I can tilt to junk bonds. I wouldn't say the credit risk as a factor was dead because junk bonds had a bad long period where treasuries outperformed. But, obviously, determining credit worthiness is not a perfect science either.
The same thing applies for stock factors. The Fama and French model attempts to distill what risk factors exist among stocks. Could be all completely data-mined artifacts. Personally, I don't think that is likely but certainly the model isn't reality either. The big question is if targeting a tilt with low price/book, for example, would allow you to take on additional risk for potentially greater return. Like taking on more credit risk in a bond portfolio. We don't know and we won't know for a long time.
Further, with bonds you know the nominal interest rate you will get versus the relative risk you are taking. With stocks, there is no guarantee of additional return for taking additional risk. The double unknowns in stock investing is the reason why stock investors have to see the potential for significant increased returns of stocks versus bonds to entice them to risk their money in stocks.
Statistics: Posted by TimeIsYourFriend — Wed Mar 06, 2024 8:40 am — Replies 25 — Views 1658