This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
TheStreet Open House

Fama-French Three Factor Model

By: Frank Armstrong

The Fama-French Three Factor Model provides a highly useful tool for understanding portfolio performance, measuring the impact of active management, portfolio construction and estimating future returns. The Three Factor Model has replaced Capital Asset Pricing Model (CAP-M) as the most widely accepted explanation of stock prices in the aggregate and investor returns.

CAP-M: A First Cut at the Problem

To review, and greatly oversimplify, CAP-M established the relationship between risk and reward. The market would set stock prices, and investors achieve returns directly related to risk. Said another way, investors would drive down the price of stocks until the expected return for owning them compensated them for the risk that the stock exhibited.

CAP-M explains stock performance, or investor returns as the sum of:

The zero risk returnThe market premiumA return for individual security risk proportional to its volatility relative to the market (Beta)The impact of management (Alpha)Random Error

So, stocks with higher volatility relative to the market would command lower prices and achieve higher expected returns. As an example, suppose we had a stock (or a portfolio of stocks) that was 20% more volatile than the market, and that the treasury bill yielded 3% and the S&P 500 return was 11%. Market premium was then the difference between the T-bill and market or 8%. Beta is 0.2 times the market premium or 1.6%

3.00 The zero risk return

8.00 The market premium

1.60 Beta (0.2 X 8.0)

Alpha

Random Error

12.60 Expected Total Return

The market will adjust the price of the stock to the point where an investor can expect a 12.20% average return.

Had the stock (or a portfolio with a Beta of 1.2) returned, for instance, 13.20% then the unexplained difference (Alpha) would have been presumed to be due to management impact. In that case, Alpha would be presumed to be 0.60%. (Let's be real here. A portfolio manager that happened to have a higher than expected return is hardly going to attribute it to random error! Of course not. He is going to claim that the result was due to his superior skill and cunning.)

1 of 5

Select the service that is right for you!

COMPARE ALL SERVICES
Action Alerts PLUS
Try it NOW

Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
  • Weekly roundups
TheStreet Quant Ratings
Try it NOW
Only $49.95/yr

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
  • Upgrade/downgrade alerts
Stocks Under $10
Try it NOW

David Peltier, uncovers low dollar stocks with extraordinary upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
  • Weekly roundups
Dividend Stock Advisor
Try it NOW

Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Alerts when market news affect the portfolio
  • Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
Real Money Pro
Try it NOW

All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.

Product Features:
  • Real Money + Doug Kass Plus 15 more Wall Street Pros
  • Intraday commentary & news
  • Ultra-actionable trading ideas
Options Profits
Try it NOW

Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • 100+ monthly options trading ideas
  • Actionable options commentary & news
  • Real-time trading community
  • Options TV
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!
DOW 16,380.41 +263.17 1.63%
S&P 500 1,886.76 +24.00 1.29%
NASDAQ 4,258.4380 +41.0480 0.97%

Brokerage Partners

Rates from Bankrate.com

  • Mortgage
  • Credit Cards
  • Auto

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs