Efficient Market Hypothesis
“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.
The Three factor Model
The Three Factor Model is a model that defines three independent dimensions of returns. It is probable to apply these factors to portfolios and then quantify the role each factor provides to the overall portfolio as a whole.
In 1991 Eugene F. Fama and Kenneth French who are two leading economists, led a study into the sources of risk and return. Based around the Efficient Market Hypothesis, their research showed that a portfolio’s exposure to three simple but diverse risk factors determines the clear majority of investment results.
The three factors are referred to as the Three-Factor Model.
- 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
Evidence and academic based investing utilizes the Three Factor Model and it allows engineering of portfolios where the allocation between equities and fixed income and allocation between small vs large and value vs growth equities can be based on academics and not guess work.
Source: Fama, Eugene. “Random Walks in Stock Market Prices”. Financial Analysts Journal, September/October 1965
Modern Portfolio Theory
Modern Portfolio Theory and its inventor Harry Markowitz earned the Nobel prize in economics in 1990 for his work on portfolio risk and reward. Modern Portfolio Theory essentially explains how investors can reduce overall risk by holding a diversified portfolio of assets and at the same time it allows individuals to maximize their expected returns based on the amount of volatility they are willing to take.
Having asset that have dissimilar movement (low correlation) will reduce the risk of the portfolio and can be achieved through a global diversification model