In 1992, two finance professors, Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College, turned the world of finance on its head by demonstrating that the prevailing theory of portfolio returns did not work well.
They reported that the old method (the Capital Asset Pricing Model), which attributed portfolio returns to its volatility relative to the broad stock market, was not very good at explaining portfolio returns. Fama and French added two additional risk factors to the model (small stock and value stock exposure) and that new model (the Three Factor Model) turned out to be excellent at explaining returns.
Most importantly, the model allowed investors to clearly differentiate between investing and speculating. Portfolio exposure to priced risk (systematic, economic and long-term) was now associated with investing and exposure to un-priced risk (stock picking and market timing) was now considered speculating.
These finding caused many investment professionals to think about portfolio construction differently than they had in the past. Investors had a new improved model to use to consider the kind of risk they should take and the kind of risk they should avoid.
After 20 years, the Fama-French Three Factor Model continues to be the best available tool for thinking about risk and reward in a stock portfolio. We are confident that Fama and French’s research will continue to serve as an important part of a successful investment process for many years to come.
If you would like to read a more detailed explanation of the Fama and French research click here.