IFA Radio's Episode 27

IFA Radio
Friday, July 02, 2010

 In honor of the United States’ Independence Day, the radio program this week highlights the passive investor’s life, which is free from excessive fees, active managers, and market timers. By building a passive portfolio based on Markowitz’s “Modern Portfolio Theory”, investors are able to sleep better at night—invest and relax. But, how can an investor expect their portfolios to be safe with the constant, random fluctuations of the stock market? This program discussion centers on the inner workings of the market and how it works.

 
In essence, the entire market scheme is simply about the price of securities at the end of the day. To realize this statement, we need to take into account the “Hebner Model.” This model plainly elucidates how prices are set on the free market. 
 
 
The Hebner Model attempts to simplify free market forces into 3 simple variables: Price, Expected Return and Economic Uncertainty (News). In short, prices move in the opposite direction of economic uncertainty so that expected returns at a specified level of risk can remain essentially constant. The only way to alter the expected return is to alter the risk of a diversified portfolio held and rebalanced to maintain the risk of the whole portfolio over time.
 
At the foundation of the model is Eugene Fama's Efficient Market Hypothesis, which says that market prices are fair. This implies the price fully reflects all available information or news, including economic uncertainty at the moment of the trade, new information concerning the investment, and the predictions on the probabilities of future information. 
 
Hebner discusses the underlying determinant of price by saying, “The job of free market participants is to set prices so that investors will be compensated for the risk they bear.” The truth of this statement is the foundation for capitalism. The spontaneous order of the market is essentially why capitalism works and continues to thrive as a system. By allowing the buyers or investors to assist in setting the price of the products sold, a price is discovered at which the investor will be compensated for the risk they take in buying the product. In this light, the price is found through a spontaneous order of news inflow. The only determinant able to affect the level of price is new information. 
 
At the core of the Hebner Model, investors can rest assured with proven evidence illustrating that the markets are only inefficient in the short term. In the long term, markets do reflect all available information or economic uncertainty. Nevertheless, investors will be compensated for bad news by the resetting of prices. As discussed, an IFA client is quoted for saying that on March 9 (the lowest point in the stock market decline) he “saw nothing but darkness on the horizon.” For the investors who rode this period of downturn through, markets responded with a sharp increase the very next day, and would go on to recover with 3 to 4% daily increases over the following weeks. 
 
As Hebner reaffirms this week with the efficiency of the market, the key to investing is manifested in a passive investment approach through the use of index funds. Over a risk appropriate holding of the value of an investment, a positive expected return is produced from a level price where investors will be compensated for the overall risk they bear.

 

 

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