8 – M4 L1B 08 Risk Factors V Alpha Factors Part 2 V2

We generally observe different attributes among risk factors versus alpha factors. Even though factors fall along a graded incremental spectrum of these attributes, it helps to put them into two groups to get a sense of how risk factors and alpha factors differ. One difference is in the magnitude of the factors contribution to the stock’s price movement. When we choose a set of 20 or so risk factors that explain a good portion of the variance of stocks, then taken as a whole, these risk factors tend to be major contributors to the price movement of most stocks. These are factors such as the market return, the country in which the company operates, the sector or line of business, and interest rates set by central bank. In comparison, a single alpha factor may have a smaller contribution to a stock’s price movement. As an example, the book-to-market ratio multiplied by idiosyncratic volatility or the trajectory of a stock’s return over time are examples of potential alpha factors. You will actually get an in-depth look at these two alpha factors in a later lesson. But for now just assume that we’re talking about two examples of alpha factors. The contribution of these alpha factors may be statistically significant, but in terms of magnitude, their impact on the variance of the stock may be smaller than that of a set of common risk factors. This is an important reason for why we want to find a useful set of risk factors and neutralize our portfolio’s exposure to them. If we didn’t, then the portfolio’s movements due to these risk factors would likely be so large as to overwhelm the effects of the alpha factors.

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