2 – M4 L3a 02 Alpha Factors Versus Risk Factor Modeling V2

Since we just talked about risk factors, let’s talk about how both the risk and alpha factors help us create successful portfolios and how they’re different. We use risk factors in risk factor models to help us model the movement of our stocks prices due to common publicly known factors that may explain price movements in a broad cross-section of stocks defined as systematic returns and systematic volatility. Since these risk factors may significantly impact our portfolio volatility without providing appropriate compensation in the form of returns, our goal is to neutralize the portfolio’s exposure to these risk factors, so that their remaining movements of stocks in our portfolio can be attributable to our alpha factors. We can use an analogy where factors are sounds that you hear when eating lunch at a busy restaurant. Risk factors are like the background noise, like the conversations of all the patrons, the noise from the servers and the kitchen noises. The alpha factors are like the soft voices of your friends who are sitting with you for lunch. If we don’t neutralize the background noise, it may drown out the sound of your friends voices. Similarly, alpha factors have important information that may be overwhelmed by the movements of risk factors such as the movements of the market or movements of a sector. We want to isolate the effect of alpha factors. To do that, we eliminate the effect of risk factors.