Factor investing is an investment strategy that includes selecting companies based on certain characteristics or variables that are expected to impact their returns. These characteristics may include value, size, growth, quality, and stability. The key difference between Factor investing and traditional investing is that subjective judgment is not used in stock selection when it comes to Factor investing. The investor’s duty here is to create investing rules based on their own knowledge and study. Once the rules are defined, there is no choice for subjective assessment.
Investors can back-test their parameters to determine if these rules have produced good outcomes in the previous ten, fifteen, or twenty years. Still, the main difference between a back-test and real-world investing is the investor’s psychological makeup. Things change when your money and future are on the line. The emotional and mental obstacles of putting real money on the line might be vastly different from the controlled setting of a back-test or simulation. When an investor’s personal wealth is at stake, the temptation to succeed can be enormous. Even carefully thought-out factor investing methods can be undermined by fear of losing money, the desire to stray from a plan amid market turbulence, and the challenge of being disciplined in the face of volatility.
We have enjoyed years and years of healthy equity markets and an expanding economy. The fact is that at the times of good market movements, there are several successful ways. It’s easy to claim that investors have improved. But the genuine explanation is that markets have been performing well for a long time. In the stock market, there is an ancient phrase that goes, “A rising tide lifts all boats.” The true test comes when the tide starts to recede.
Having a great understanding of market patterns sets seasoned investors apart from others who have only dabbled in the markets. Experienced investors understand that no matter how powerful the trends look, they are just short-lived. Their broad knowledge and recall of prior market cycles serve as a continual reminder that what rises must fall and vice versa. This awareness enables them to address the ever-changing market situation with a level mind. However, the key to investment success is not just knowing the market cycle, but also regulating one’s psychological reaction to it. As the market proceeds through its many stages, investors experience a matching psychological cycle as well. An investor’s financial performance and ability to meet his long-term financial goals ultimately depend on his or her capacity to identify and successfully navigate these unique psychological periods.
In summary, managing one’s psychological response to market volatility is as important as understanding the market and the forces that influence it.
