What are the main components of the Fama-French three-factor model?

The Fama-French three-factor model is a widely used financial model that expands on the traditional Capital Asset Pricing Model (CAPM) by identifying additional factors that can explain asset returns beyond just market risk. The main components of this model are market risk, the size effect, and the value effect.

Market risk refers to the systematic risk of the overall market that cannot be eliminated through diversification. It captures the sensitivity of a stock's return to the overall market return.

The size effect acknowledges that smaller companies tend to outperform larger companies on a risk-adjusted basis. This phenomenon can be attributed to several factors, including lower analyst coverage and higher growth potential in smaller firms.

The value effect indicates that stocks with low price-to-earnings ratios or low book-to-market ratios tend to outperform stocks with high price-to-earnings ratios or high book-to-market ratios. This suggests that undervalued (or "value") stocks can yield higher returns than growth stocks.

These three components combine to provide a more comprehensive understanding of stock returns, addressing some of the limitations of models that only consider market risk.