Earlier, we've explored some techniques for optimizing portfolio based on the expected returns of individual assets.

Another important question in portfolio analysis - whether returns and risks of our portfolio could be affected by external factors?

This question leads to the concept of Factor Analysis.

What is Factor Analysis?

To start, let’s define the key term for this topic.

In practice, certain known factors, like financial indicators, can impact the return of our portfolio.

Factor Analysis examines how these factors influence a portfolio.

Classification of Factors

Generally, we can divide factors into two categories: Macro factors and Style factors.

Macro Factors

For instance, Macro Factors include:

• Gross Domestic Product (GDP) - measures a total value of all goods and services produced within a country over a specific time period, where growing GDP is one indicator of a healthy economy, which can boost prices of assets;
• Inflation - rate at which the general price level of goods and services rises, where high inflation can reduce purchasing power;
• Interest rates - tools used by central banks to manage economic growth and inflation;
• Unemployment rate - represents percentage of the labor force that is unemployed and actively seeking work.

Style Factors

Here are several examples of Style Factors:

• Value - indicates whether stocks are undervalued compared to their intrinsic worth (stock prices are low relative to their earnings, assets, or other financial metrics);
• Quality - ability of asset to have high profitability and low leverage;
• Size - refers to the market capitalization of a company;
• Momentum - captures the tendency of assets that have performed well in the past to continue performing well in the short term, while those that have underperformed tend to lag behind.

Please note that these are just a few examples of factors.

In the following chapters, we will discuss models that describe dependencies between a portfolio's return and specific factors.