Previous posts covered individual indicators: PER, ROE, momentum, dividend yield. The question now is “how to combine these indicators into a single score, and how to construct and manage a portfolio from that score.”
Factor Investing
Factor investing systematically selects stocks based on specific characteristics (factors). “Buy low-PER stocks” is a form of factor investing — selecting stocks based on the PER factor.
Single Factor vs Multi-Factor
Single-factor strategies select stocks using one indicator. Low-PER strategies, high-ROE strategies, and high-momentum strategies fall into this category. They are intuitive but limited. As covered earlier, low-PER stocks can be value traps, and high-momentum stocks may already be overvalued.
Multi-factor strategies combine multiple indicators into a composite score. By reflecting multiple perspectives — value, quality, momentum, dividend — simultaneously, they compensate for each individual factor’s weaknesses. Both academic research and practice consistently show multi-factor approaches producing more stable results than single-factor ones.
When constructing a multi-factor strategy, assign weights to each factor. Equal weighting (same weight for all factors) is the simplest approach. To emphasize a particular factor, increase its weight. There is no single correct weighting — validation through backtesting is required.
Factor Scoring
Combining multiple factors into one score requires converting each factor’s values into comparable units. PER operates in the 10s, ROE in percentages like 15%, and momentum in decimals like 0.3. Adding values with different scales directly causes certain factors to dominate the score.
Z-Score
Z = (Value - Mean) / Standard Deviation
Z-Score indicates how many standard deviations each value is from the mean. It transforms all factors to the same scale with mean 0 and standard deviation 1.
Z-Score’s advantage is preserving distribution information. It reflects the difference between exceptionally good stocks and average ones. The disadvantage is sensitivity to outliers. A single stock with PER of 1,000 compresses all other stocks’ Z-Scores near zero.
Rank
Rank-based scoring uses rankings instead of raw values. Among 100 stocks, the one with the lowest PER ranks 1st, the highest ranks 100th. Rankings are normalized to a 0-1 range for scoring.
Rank’s advantage is robustness to outliers. A stock with PER of 1,000 simply receives the last rank without affecting other stocks’ scores. In practice, Rank is used more frequently than Z-Score.
lower_is_better Handling
PER, PBR, and debt ratio are better when lower. Momentum, ROE, and dividend yield are better when higher. When combining factors with different directions into a single score, “lower is better” factors must have their signs inverted or rankings reversed. Missing this step causes scores to work opposite to intent.
Rebalancing
Rebalancing restores a portfolio to its target allocation after it drifts. Over time, differing returns across holdings cause the actual allocation to diverge from the initial target. Periodically reverting to the original allocation is rebalancing.
Rebalancing Frequency
| Frequency | Characteristics |
|---|---|
| Daily | Most precise but highest transaction costs |
| Weekly | Balance between cost and precision |
| Monthly | Most common choice |
| Quarterly | Lowest cost but larger allocation drift |
Rebalancing too frequently accumulates transaction costs. Rebalancing too rarely allows significant drift from intended allocations. Monthly rebalancing is the most widely adopted compromise.
Rebalancing Bands
Trading at every rebalancing date regardless of drift is inefficient. Rebalancing bands set a rule: “trade only when allocation deviates from target by more than a threshold.” Small deviations are left alone; trades occur only when the threshold is crossed. This reduces unnecessary transactions and saves costs.
Asset Allocation
Asset allocation distributes capital across multiple asset types. Beyond stocks, it includes bonds, gold, commodities, and other assets.
The Principle of Diversification
“Don’t put all your eggs in one basket” captures the essence of asset allocation. When stocks decline, bonds may rise. During inflation, gold may appreciate. The lower the correlation between assets, the greater the diversification benefit.
The goal of asset allocation is not maximizing returns. It is maintaining adequate returns while reducing risk. A 60% stocks + 40% bonds portfolio yields less than 100% stocks, but MDD decreases significantly.
Traditional Allocations
| Allocation | Characteristics |
|---|---|
| 60% Stocks + 40% Bonds | The most traditional balanced portfolio |
| 80% Stocks + 20% Bonds | Growth-oriented. Sometimes recommended for younger investors |
| 40% Stocks + 40% Bonds + 20% Gold/Commodities | All-weather style multi-asset allocation |
No single allocation ratio is universally correct. It depends on the investor’s goals, time horizon, and risk tolerance.
So far, this series covered indicators for evaluating companies (PER, PBR, ROE, debt ratio), reading market trends (momentum, dividends), validating strategies (backtesting), and constructing portfolios (factor scoring, rebalancing, asset allocation).
The next post shifts perspective to technical indicators — reading buy/sell timing from price movements themselves.
References
- Investopedia — Factor Investing
- Investopedia — Rebalancing
- Investopedia — Asset Allocation
- Investopedia — Z-Score
- Andrew Ang, Asset Management: A Systematic Approach to Factor Investing (2014)