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How do these risk premiums behave through various stages of a business cycle? Exhibit 2.11 displays the rolling 24-month average returns on the two factors discussed in Exhibit 2.10.

Clearly, these two factors display significant time variations. As previously mentioned, we must expect factor premiums to display some volatility and to perform differently during various stages of the business cycle. If there were no risks, then there would be no premiums. For instance, the book-to-market factor (i.e., value factor) tends to produce attractive risk-adjusted returns during normal market conditions but have poor risk-adjusted returns during economic downturns.19 The momentum factor tends to produce positive returns most of the time but has a tendency to display large negative returns over a short period of time when a market correction takes place. Momentum is notorious for performing poorly during momentum crashes. A momentum crash occurs when those assets with recent overperformance (i.e., those assets with momentum) experience extremely poor performance relative to other assets (Asness et al. 2010). In the same way that investors have learned to hold diversified portfolios in terms of asset classes, they should hold diversified portfolios in terms of risk factors.

EXHIBIT 2.11 Rolling 24-Month Average Returns to Factors

Source: K. French Data Library.