How many factors should you have in an equity? The factor zoo is constantly expanding, so you must be continually on the lookout for the next new factor, yet there should be a limit on the number. So, how do you determine the correct number of factors? Felix Goltz suggested that the number should be based on the three Ps - Pervasive, Plausible, and Practical. This is simple, easy to remember, and can be implemented by any investor. Of course, there is much room for interpretation concerning these three P's, but that is a deeper discussion.
Pervasive - A factor should stand the test of time, apply across different asset classes, and be verified through independent research.
Plausible - A factor should have a strong theoretical foundation and a straightforward narrative that can explain its presence.
Practical - A factor should still be present despite transaction costs and should not deteriorate as more investors use it.
If you have only 3 factors, you will likely be too stringent with your three P's. If you are getting to a number greater than a dozen, it is likely you should review your criteria. Perhaps these numbers are not wide enough, but this is a good start for forming a process for testing and inclusion.
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