Free Market Forces

Market Forces
Market Forces

The job of free markets is to set prices so that investors are rewarded for the risks they take. To help explain this important statement, I created a model, which attempts to simplify market forces into three variables: Price, Expected Return and Uncertainty. Prices move inversely proportional to economic uncertainty so that expected returns at a specified level of risk can remain essentially constant, resulting in a fair price. From fair prices we expect fair returns, meaning that investors should be compensated for their risk exposure over an appropriate period of time.

The reason people invest is to get a return. At the time of a trade, buyers pay a price that reflects the risk associated with capturing the expected return. In other words, a fair price equals a fair expected return.

This model is based on Eugene Fama’s Efficient Market Hypothesis, which states that prices fully reflect all available information or news, economic uncertainty and probabilities of future events, thus implying that market prices are fair.

The model shown in the following painting attempts to diagram the three variables of Price, Expected Return and Uncertainty, resulting in a distribution of actual monthly returns shown at the bottom. The diagram shows the essentially constant expected return of a diversified investment portfolio held constant with 50% stocks and 50% bonds. Index Portfolio 50 is shown at the fulcrum of the teeter-totter, and the period-specific expected return can be estimated based on 50 or 86 years of simulated historical returns, the Fama/French Five-Factor Model, or any reasonable method an investor chooses. Current news impacts economic uncertainty and is represented on the left side of the teeter-totter. This economic uncertainty includes the probabilities of future events as estimated by the buyers and sellers. The price agreed upon by willing buyers and sellers is on the right side.  Prices move inversely proportional to shifts in economic uncertainty so that expected returns remain essentially the same for a given level of risk.

From a fair price investors should expect: 1) a fair outcome, which would be a risk-appropriate or fair return; 2) an equal chance of being greater than or less than that fair return; and 3) the farther the actual return is from the expected return, the lower the probability of its occurrence.

So before you trade, ask yourself: 1) Who is on the other side of my trade? 2) Do I think I know more than they do?
3) Am I paying a fair price? In my opinion, your answers are as follows: 1) You don’t know; 2) It’s highly unlikely; and 3) If there are many willing buyers and sellers, by definition, it is a fair price.

Time pickers cannot forecast the direction of the market because they cannot know the next news story. There is no competitive edge that exists other than illegal inside information. The best way to earn the market’s fair return is to simply remain invested at all times in a relatively low-cost, passively managed index portfolio (also see hebnermodel.com).

Step 4Hebner ModelEugene FamaFive Factor ModelThree Factor Model