A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

THE 
FAMA-FRENCH 
RISK
FACTORS
Beta: from the Capital-Asset Pricing Model
Size: measured by total equity market
capitalization
Value: measured by the ratio of market to book
value

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Some analysts would add further variables to the Fama-
French three-factor risk model. A momentum factor could be
added to capture the tendency for rising or falling stocks to
continue moving in the same direction. In addition, a liquidity
factor could be added to reflect the fact that investors need to
be paid a return premium to induce them to hold illiquid
securities.
A SUMMING UP
Chapters 8 and 9 have been an academic exercise in the
modern theory of capital markets. The stock market appears
to be an efficient mechanism that adjusts quite quickly to new
information. Neither technical analysis, which analyzes the
past price movements of stocks, nor fundamental analysis,
which analyzes more basic information about the prospects
for individual companies and the economy, seems to yield
consistent benefits. It appears that the only way to obtain
higher long-run investment returns is to accept greater risks.
Unfortunately, a perfect risk measure does not exist. Beta,
the risk measure from the capital-asset pricing model, looks
nice on the surface. It is a simple, easy-to-understand

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measure of market sensitivity. Alas, beta also has its warts.
The actual relationship between beta and rate of return has
not corresponded to the relationship predicted in theory
during long periods of the twentieth century. Moreover, betas
for individual stocks are not stable over time, and they are
very sensitive to the market proxy against which they are
measured.
I have argued here that no single measure is likely to
capture adequately the variety of systematic risk influences
on individual stocks and portfolios. Returns are probably
sensitive to general market swings, to changes in interest and
inflation rates, to changes in national income, and,
undoubtedly, to other economic factors such as exchange
rates. Moreover, there is evidence that returns are higher for
stocks with lower price-book ratios and smaller size. The
mystical perfect risk measure is still beyond our grasp.
To the great relief of assistant professors who must
publish or perish, there is still much debate within the
academic community on risk measurement, and much more
empirical testing needs to be done. Undoubtedly, there will
yet be many improvements in the techniques of risk analysis,
and the quantitative analysis of risk measurement is far from

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dead. My own guess is that future risk measures will be even
more sophisticated—not less so. Nevertheless, we must be
careful not to accept beta or any other measure as an easy
way to assess risk and to predict future returns with any
certainty. You should know about the best of the modern
techniques of the new investment technology—they can be
useful aids. But there is never going to be a handsome genie
who will appear and solve all our investment problems. And
even if he did, we would probably foul it up—as did the little
old lady in the following favorite story of Robert Kirby of
Capital Guardian Trust:
She was sitting in her rocking chair on the porch of the
retirement home when a little genie appeared and said,
“I’ve decided to grant you three wishes.”
The little old lady answered, “Buzz off, you little
twerp, I’ve seen all the wise guys I need to in my life.”
The genie answered, “Look, I’m not kidding. This is
for real. Just try me.”
She shrugged and said, “Okay, turn my rocking chair
into solid gold.”
When, in a puff of smoke, he did it, her interest
picked up noticeably. She said, “Turn me into a

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beautiful young maiden.”
Again, in a puff of smoke, he did it. Finally, she said,
“Okay, for my third wish turn my cat into a handsome
young prince.”
In an instant, there stood the young prince, who then
turned to her and asked, “Now aren’t you sorry you had
me fixed?”

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