Three-Factor Model for Portfolio Management

Before going farther into the article, let me give you a brief idea about Portfolio Management. Portfolio management comprises of all the programs and projects that are prioritized by business objectives. Priorities are set through an appropriate value optimization process for the administration. Danger and wages are balanced and seen, and the programs are chosen based on their alliance with organizational scheme.

The three-factor model was developed in 1993 by Eugene Fama and Kenneth French. Hence it is also known as the Fama and French model. This three-factor model is widely examined by fund managers and investors to analyze and return linked market/instruments to make the highest return for the risk taken.

CAPM (Capability Asset Pricing Model) model is the original model of the three-factor model. Hence, it is necessary to understand this model, for a easy understanding of the three-factor model. The formula of CAPM is: R= Rf+ beta * (Rm -Rf), where R is the return, Rf is the return rate of risk-free investments, beta is the risk associated with a security market, and Rm is the return rate expected from the market. CAPM model successfully explains around 80% of returns.

The formula of three-factor model is: R= Rf + beta* (Rm-Rf) + Bs*SMB+ Bv* HML.SMB is called as the Small Minus Gap, and HML is known as "High Minus Low". Bs and Bv are betas corresponding to small cap and large cap portfolios having values of either 0 or 1.

The idea behind this model is that, value and small cap stocks often outperform large- cap stocks. The potential reasons for this could be a higher reward for covering higher risk taken and early mispricing of equities. Fundamentally small-cap companies often show better growth and this is reflected on their stock prices.

This model has helped a number of investors and fund mangers to calculate their risks and profits, thereby diversifying their portfolio management and minimizing risk strategies.