Take a look at your brokerage account, IRA, or 401(k). Do you see anything in there with Large Cap, Value, Growth, or Small Cap in the title? If so, you’re already investing with Factors. A very large proportion of American households use investments based on Factors but few are aware of what a “factor” is or why one should be used.

The purpose of this article is not to make you an expert on Factors. This is the first in a series of Factor based investing articles we plan on publishing over the coming months.The purpose of this article is to get you started and give you the vocabulary you need to learn more about the investments you’re making.

In the following article, we’re going to define what Factors are and then introduce the 6 major Factors you need to know about. Once you’ve learned what those 6 Factors are, you’ll be ready to read up on each individual Factor in subsequent articles.

There are a lot of great resources out there to help you learn about Factor investing. Many of them avoid defining what a Factor is. While it might sound technical at first, it’s important to learn what a Factor is before you truly understand the Factors themselves.

In our above definition, we describe Factors as something that we can identify as a contributor to the difference between the norm and an individual stock or grouping of stocks. A Factor is a Contributing Factor. It helps when you’re learning about Factors to repeat that to yourself whenever you see the word itself: when you hear Factor, think Contributing Factor.

Now, think about every stock in the entire world. Imagine putting them on a massive scatter-plot, with points all across the board showing returns and risks of each one. They’d be all over the place. What if we could describe at least part of what put these stocks where they are on that chart?

Factor is just a fancy word for doing exactly that. A Factor is a description of why a certain stock behaves differently from the average stock. For example, all small companies of a certain size that are based in America have similarities in risk/reward trade off over the long run. They behave similar to each other as a category, and all behave different from large companies similarly. Size is a Factor.

Furthermore, with Small companies, there are some companies that have low valuations compared to their earnings. These are called Value stocks. Small company Value stocks resemble each other even more.

The size of a company was one of the first Factors behind variance from the norm ever demonstrated. Mainstream finance now acknowledges a handful of other factors: Value; Quality; Dividends; Momentum; and Low Volatility. Each of these Factors has some degree of academic evidence as a real descriptor of why a stock might behave differently from the average stock.

I’d be remiss in not mentioning the names of two academics that have contributed immensely to our understanding of factors: Eugene Fama and Kenneth French. I don’t recommend running out and reading their work once you’ve finished this article just yet. It is quite rich with the language of statistics and technical lingo. If you do go out and read up on Factors after this, you will hear their names often.

Just to reiterate, all of the six following Factors have been identified as outperforming the norm at different periods on a long enough time scale:

Easily one of the best known and most popular Factors, Value is simply stocks that have low prices relative to their value (and compared to other stocks in their category). Ideally, you’re looking for stocks that are “cheap.” Different Mutual Funds, ETF’s, and investors will define “cheap” using different measures: Price to Earnings (aka P/E in the financial press), Price to Cash Flow, etc. It’s important to note that the Value Factor is different from the Investment Philosophy known as Value Investing pioneered by Warren Buffett.

At first blush, some investors make the assumption that Low Volatility is about low risk investing. That’s not the case- many Low Volatility companies are every bit as high risk as any other cyclical business model. But there’s research showing companies with low volatility outperform on a risk-adjusted returns basis. Measuring risk by Standard Deviation on a rolling 3 year time frame is one popular way of determining what is Low Volatility.

One of the simplest Factors to both understand and measure is size: Small companies outperform (and have higher risk) than Large, Mid, and Mega sized companies. Small companies are determined entirely by Market Capitalization. Small Capitalization (aka Small Cap) stocks are what we’re talking about here.

Quality refers to the fiscal stability and responsibility of a company. For example, high quality earnings are genuine high margin earnings without too much enterprise debt burden. It’s well known that high quality companies outperform. What is not agreed upon is how quality is measured. Earnings and Governance consistency and stability are generally agreed upon as indicators of quality. Some investors focus on popular fiscal metrics and ratios.

Have you ever heard the saying “the winners keep winning”? Momentum tries to capitalize on that. Stocks that performed well before continue to earn outsized returns in the future. This is the most disputed Factor that I’m aware of. These stocks tend to be related to “Growth” stocks. Momentum is measured variously, but is based on the returns of the stock (rather than the fundamentals of a company such as with Quality or Value).

Companies that pay dividends outperform companies that don’t. From there, the Dividend Factor becomes a diverse field of thought: some Dividend Factor investors believe that dividend growth, rather than purely high yielding dividends, is a driver of performance (as we at Chaim Investment Advisors believe). Others focus on high yielding dividend stocks, believing that growth is less important than current yield. Both of these have a great deal of academic support. This factor must always be applied carefully: some companies that are genuinely low quality companies pay high dividends. Investors, Mutual Funds, and ETF’s that are legitimate quantitative investing focused firms generally avoid these infamous “dividend traps.” As such, other measures of financial health are typically used in combination with a focus on dividends to avoid these pitfalls.

We believe that Factor based investing will only continue to grow from here. The proliferation of inexpensive ETF’s and the steady research advances made by quantitative analysts has populated the investing universe with Factor investing options. It’s now quite rare to see a 401(k) or 403(b) that does not offer a Small Cap or Value fund. Now that you have an idea of what a Factor is and understand a little bit about what each one, as well as how it’s measured, continue to look at your investments for Factor based investment theories. In the next articles, we’ll be looking at each of these six factors one by one.