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

However, a question still lingers: why do we achieve such returns?

This question leads to the concept of Factor Analysis.

What is Factor Analysis?

First of all, let's define what is a factor.

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 country's total economic output, where high GDP indicates a healthy economy, which can boost assets prices;
• Interest Rates - are tools used by central banks to manage economic growth and inflation;
• Inflation - is rate at which the general price level of goods and services rises., where moderate inflation is often viewed as a sign of economic growth, while high inflation can reduce purchasing power;
• 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 - this investment strategy focuses on identifying stocks that are undervalued compared to their intrinsic worth;
• 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.