Why good companies are not always good investments
Fama and French’s famous 1993 paper, “Common Risk Factors in the Returns on Stocks and Bonds,” changed the way investors think about stock returns. Before this paper, many investors relied heavily on the Capital Asset Pricing Model, or CAPM, which says stock returns are mainly explained by market risk. Fama and French showed that this was too simple. Stock returns are better explained by three key factors: market risk, company size, and value characteristics.
Stock market returns are not driven by market movement alone. Smaller companies and value stocks often behave differently from large growth companies. Investors who understand these risk factors can better explain why some portfolios outperform, why some cheap stocks recover, and why some popular stocks disappoint.
The big idea
The paper introduced what would later be widely known as the Fama-French Three-Factor Model.
The three factors are:
Factor Meaning Simple explanation
Factor | Simple meaning | Simple statement |
| Market factor | Overall market risk | Stocks usually move up or down with the wider stock market. |
| Size factor | Small companies versus large companies | Smaller companies may be riskier, but they can sometimes give higher returns. |
| Value factor | Cheap stocks versus expensive growth stocks | Cheap or unpopular stocks may sometimes perform better than expensive growth stocks. |
Why this matters to investors
Many people believe successful investing means buying high-quality companies. Fama and French remind us that price and risk matter. A great company bought at a high price may give poor returns. A neglected company bought cheaply may produce better returns.
This is why valuation matters.
7 key lessons from the paper
- Market risk alone does not explain stock returns
CAPM says the main driver of stock returns is market beta. Fama and French found that beta alone was not enough. Some stocks earned higher or lower returns than beta could explain. - Small companies behave differently
The paper found that small-cap stocks have return patterns that differ from large-cap stocks. This does not mean small stocks are always better. It means they carry different risks. - Value stocks matter
Stocks with high book-to-market ratios, often seen as value stocks, showed different return behaviour from growth stocks. This supports the idea that cheap stocks may carry hidden risk, but may also offer higher expected returns. - Risk and return are linked in more than one way
The old thinking was simple: higher beta means higher expected return. Fama and French showed that size and value can also explain return differences. - Diversification should consider factors
A portfolio may appear diversified by holding many stocks, but it may still be exposed to the same factors. For example, holding many technology growth stocks may still leave the investor exposed to one style of risk. - Cheap does not always mean safe
Value stocks can outperform over time, but they may be cheap for a reason. Some may face poor earnings, weak balance sheets, or business decline. The paper helps explain return patterns, but it does not remove the need for judgement. - Investing is about understanding what risk you are being paid for
The best question is not “Will this stock go up?” A better question is:
What risk am I taking, and am I being paid enough for it?
Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics