Factor Allocation and Asset Allocation

Abstract

This article examines 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 1980–2014, the authors 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. The results suggest that those investors targeting higher returns should tilt toward the size and value factors, whereas investors favoring lower levels of risk should tilt toward the quality factor. This article raise questions about the current industry approach to asset allocation and the driving forces behind the magnitude of risk premiums over time.