Free Market Portfolio Theory
Free Market Portfolio Theory is the synthesis of three academic principles:
-Efficient Market Hypothesis
-Modern Portfolio Theory
-The Three-Factor Model
Together these concepts form a powerful, disciplined and diversified approach to investing.
Efficient Market Hypothesis
A fundamental component of Free Market Investing is the Efficient Market Hypothesis, first explained by Eugene F Fama in his 1965 doctoral thesis:
"An efficient market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value." Eugene F. Fama, "Random Walks in Stock Market Prices," Financial Analysts Journal, September/October 1965.
What Free Market Hypothesis means to you, the investor:
- Recognize that the stock market, the media and popular culture, by and large, encourage behavior consistent with the belief that the market is inefficient. Without a clearly defined investment philosophy, it is easy to be manipulated by media, advertisers and investment professionals eager to sell products.
- You must understand that there is a choice to be made about how you believe the market works. Do you believe it is efficient or inefficient?
- Your market belief will guide your investment strategy
Modern Portfolio Theory
The second basic component of Free Market Portfolio Theory is Modern Portfolio Theory, which earned the Nobel Prize in Economics in 1990 for the collaborative work of Harry Markowitz, Merton Miller and William Sharpe.
- The risk of an individual asset is far less important than the contribution the asset makes to the portfolio’s risk as a whole.
- For the same amount of risk, diversification can increase returns.
- The mechanism to reduce risk is dissimilar price movements; therefore, the task is to find assets with low correlations.
- The Efficient Frontier allows individuals to maximize expected returns for any level of volatility.
The Three-Factor Model
The final component of Free Market Portfolio Theory is the Three-Factor Model, which defines three independent dimensions of equity returns. There are three independent dimensions of equity returns. It is possible to apply these factors to measure the role of each factor in returns.
The 3 Factors are:
All investments contain risk and may lose value. No investment strategy (including asset allocation and diversification strategies) can ensure peace of mind, guarantee profit, or protect against loss.
- The Market Factor: the extra risk of Stocks vs. Fixed Income.
- The Size Effect: the extra risk of Small-Cap stocks over Large-Cap stocks.
- The "Value" Effect: the extra risk of high Book-to-Market (BtM) over low BtM stocks.
Investing is uncertain. Research hasn’t fully resolved the nature of risk and price movements. Until recently, much of investing involved guessing what really matters in returns. In 1991 this changed. Eugene F Fama and Kenneth R French, two leading economists, conducted an exhaustive investigation into the sources of risk and return. Grounded in Efficient Market Hypothesis (EMH), their research revealed that a portfolio’s exposure to three simple but diverse risk factors determines the vast majority of investment results. These three factors are referred to as the Three-Factor Model.
Matson Money utilizes the Three-Factor Model when engineering portfolios to determine how many equity positions to hold, the allocation between small and large equities and the allocation between value and growth equities in each of the Matson Money seven investment models. When properly educated, investors have the opportunity to apply these factors to their portfolio productively.