Factor Allocation and Asset Allocation
In this research paper, “Factor Allocation and Asset Allocation,” we examine four different asset pricing factors and their use in a portfolio that varies over time based on an investor’s risk preferences. Using data for the period 1980 to 2014, we show that the risk premiums of different factors are not constant over time, and that investors may improve their risk return trade-off by weighting or “tilting” their portfolios differently as liquidity and risk tolerances change such as when investors age. Our results suggest that those investors targeting higher returns should tilt towards the size and value factors, while investors favoring lower levels of risk should tilt towards the quality factor. Our results raise questions about the current industry approach to asset allocation and the driving forces behind the magnitude of risk premiums over time.