Multi-Factor Investment Philosophy Combined with Rebalancing and Tax-Loss Harvesting

Finally the Trifecta of investing- this is a MUST READ to learn about this powerful investing combination
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In the world of investing, strategy is everything. While the market’s whims and fluctuations are unpredictable (see my recent blog on Mr. Market), designing a robust investment portfolio based on the most appropriate factors to invest in a company along with things you can actually control can help navigate the markets daily vicissitudes.

In almost a quarter of a century of advising wealthy families on their financial life and investment portfolios, I’ve had a front row seat to every type of investment approach in the market. By trial and error, then working directly with a firm that pioneered the approach of multi-factor investing, then concentrating and specializing in quantitative finance in business school, I found that the various approaches of the multi-factor investment philosophy – when combined with dynamic rebalancing and tax-loss harvesting – stands out as an exceptional route for investors. Let’s dive into the benefits of this powerful trio.

What is The Multi-Factor Investment Philosophy?

Multi-factor investing involves choosing securities based on multiple factors that predict returns.

Multi-factor investment philosophy revolves around the idea of utilizing multiple factors to select, analyze, and allocate assets within a portfolio, rather than relying on a single factor or metric. In the context of equity investing, these factors represent certain characteristics or attributes of stocks that have historically shown the potential to earn excess returns over time.

To conceptualize this, think of a very large funnel and at the very top is every publicly traded company in the world.  Then we start to funnel down to the companies that we would want to invest in some of the factors used in this funnel based on:

Value: Stocks priced lower than their intrinsic value. I always hear about buying low and selling high, this seems pretty smart to me!

Size: Smaller companies tend to outperform larger ones over time. Why? Think about this, if you have a large company such as Apple, if they want to put money into a new project, their hurdle rate is quite low and may even be profitable in the low single digits.  A small company may have borrowed money to fund a project due to limited resources, so their hurdle rate to actually turn a profit is significantly higher than their blue-chip counterparts.

Momentum: Stocks that have performed well in the recent past. I like sports analogies; If you followed Michael Jordon in the 90’s, the Bulls generally had the momentum each year and had a higher probability of a winning season each year.

Quality: Companies with robust profitability and low debt. You should always invest in quality companies. When you are designing a portfolio, you should be investing in quality companies with sound fundamentals.

By diversifying across these factors, investors can reduce risk and potentially enhance returns.

Important note on factors, these can change over time. Think about my Michael Jordon analogy; when he left to play baseball for two seasons, the momentum shifted away. This can certainly occur with companies in which you are invested.

Key Elements of Multi-Factor Investment Philosophy

  • Diversification: By combining several factors, multi-factor strategies aim to diversify the sources of potential excess return and risk. This can lead to smoother return streams and reduced drawdowns in comparison to single-factor strategies.
  • Exploiting Market Inefficiencies: Academic and empirical research suggests that certain factors have historically been associated with outperformance. Multi-factor investing seeks to exploit these inefficiencies.
  • Adaptability: One factor might outperform in one market environment but underperform in another. By combining factors, multi-factor portfolios aim to reduce the impact of any single factor’s underperformance.
  • Diversified Risk: Since various factors may perform differently under various market conditions, multi-factor strategies can offer more consistent returns over time.
  • Potential for Outperformance: By combining factors, there’s potential to capture multiple sources of excess returns.
  • Potential Challenges of Multi-Factor Investment Philosophy
  • Complexity: Multi-factor models can be more complex than single-factor models, requiring sophisticated techniques and systems.
  • Timing: While factors have been shown to outperform over the long run, there can be prolonged periods where they underperform. This can be challenging for investors as sometimes you will hear of a friend or another advisor with better performance in the short term. If you have a long time-horizon and your portfolio is aligned with your long-term goals, this challenge is simply our behavioral reaction to the fear of missing out. If you can manage that aspect, you’re ahead of the pack.
  • Overfitting: With sophisticated models, there’s a risk of “data mining” or “overfitting” where a strategy is tailored too specifically to past data, and thus may not perform well in the future. Just because something did well in the past means nothing in the future.  Think about the Legg Mason Value fund, Bill Miller had fifteen years in a row of outperforming the S&P 500 only to suffer severe losses in 2007-2009, eliminating a fifteen-year positive track record.

Rebalancing: Ensuring Alignment with Goals

As time passes, your portfolio can drift from its original asset allocation due to varying returns of different investments. Rebalancing is the process of bringing the portfolio back in line with its original allocation. Here are the benefits:

Risk Management: It ensures that your portfolio does not become concentrated on any single asset or factor.

Potentially Higher Returns: By selling high and buying low, rebalancing can take advantage of market inefficiencies and help increase the profit margin.

For example:

  • you invest $100,000 in “XYZ” at $10 per share.
  • You invest $100,000 in “ABC” at 10 per share.
  • Total Portfolio $200,000
  • XYZ drops to $8 per share $80,000 and ABC rises to $12 per share $120,000= Total Portfolio still $200,000
    • Overexposure in ABC and Underexposure to XYZ – this portfolio is no longer aligned with its target allocation.
    • Rebalance- sell $20,000 of ABC returning the position to $100,000 and buy $20,000 of XYZ returning the position to $100,000. By purchasing more of the position that has declined you have effectively reduced the cost basis and no longer need XYZ to get back to $10 per share to break even.

Tax-Loss Harvesting: Making the Most of Losses

Tax-loss harvesting involves selling securities that have experienced a loss to offset capital gains tax liability. The proceeds can be reinvested in similar securities, maintaining the desired exposure in the portfolio.

I’m not a proponent of losing money. I’m a realist and understand there are times when really good companies are down in value. Corrections and bear markets happen all the time. Regardless of the crisis du jour, when there is an opportunity to offset a current or future capital gain tax liability, this strategy is extremely helpful.

For example, my firm advises many business owners and part of our work is exit planning, helping owners plan and prepare to exit their companies and have a liquidity event. In many cases, the tax liabilities of these business sales are significant.  Sometimes, we receive the proceeds of an exit and there is a correction in the market impacting the business owner’s personal portfolio. By effectively harvesting losses in their portfolio, we have helped to mitigate, and, in some cases, eliminate the capital gain tax liability from the business sale.

Benefits include:

  • Tax Efficiency: Reducing the capital gains tax bill can enhance after-tax returns.
  • Portfolio Boost: By reinvesting the tax savings, the portfolio gets a potential boost in growth.

The Combined Power of These Strategies

Holistic Approach: This combination provides a well-rounded strategy, covering security selection (multi-factor investing), asset allocation management (rebalancing), and tax management (tax-loss harvesting).

Enhanced Risk Management: Diversifying across multiple factors reduces reliance on a single source of return. Combined with rebalancing, this approach ensures a portfolio remains diversified and in line with an investor’s risk tolerance.

Potential for Enhanced Returns: While multi-factor investing taps into multiple sources of expected returns, rebalancing and tax-loss harvesting can further add to returns by capitalizing on market inefficiencies and tax rules.

Investing is as much about strategy as it is about prediction. With a multi-factor investment philosophy, complemented by rebalancing and tax-loss harvesting, investors can position themselves for a smoother and potentially more rewarding investment journey.

As with all strategies, it’s essential to understand the risks, ensure it fits with one’s financial goals, and regularly review the approach. But when applied judiciously and with time and patience, this trio can indeed be a game-changer.

Are you interested in learning more about Multi-Factor Investment Philosophy? Schedule a conversation.


This piece is not intended to provide specific legal, tax, or other professional advice.  Investing involves risk, including possible loss or principle.  No strategy assures success or protects against loss.   For a comprehensive review of your personal situation, always consult with a tax or legal advisor.

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