The five-factor model analysed by machine learning classification techniques

Abstract

ABSTRACT This study compares the classification performance of traditional factor models and ML to explore the assumption of linearity in risk premiums. We apply ML techniques to the variables used in the Fama – French five-factor (FF5) model to classify the top 30% and bottom 30% of stocks based on whether their prices are expected to increase (winners) or decrease (losers), respectively, over a specified time period. The analysis showed that the ML model’s classification Accuracy outperforms the FF5 classification, which suggests that the higher returns obtained using the FF5 model can be attributed to its effectiveness in classifying stocks with exceptionally high or low returns, rather than the comprehensive use of its variables for overall classification purposes.