Fama And French Three Factor Model

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DEFINITION of 'Fama And French Three Factor Model'

A factor model that expands on the capital asset pricing model (CAPM) by adding size and value factors in addition to the market risk factor in CAPM. This model considers the fact that value and small cap stocks outperform markets on a regular basis. By including these two additional factors, the model adjusts for the outperformance tendency, which is thought to make it a better tool for evaluating manager performance.

BREAKING DOWN 'Fama And French Three Factor Model'

Fama and French attempted to better measure market returns and, through research, found that value stocks outperform growth stocks; similarly, small cap stocks tend to outperform large cap stocks. As an evaluation tool, the performance of portfolios with a large number of small cap or value stocks would be lower than the CAPM result, as the three factor model adjusts downward for small cap and value outperformance.

The outperformance is generally explained by the excess risk that value stocks face as a result of  buying out of favor stocks or stocks with depressed prices, and what small cap stocks face as a result of their higher cost of capital and competitive disadvantage. 

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