Three Components of Free Market Portfolio Theory

Businessman is drawing on virtual screen. free market concept.


When it comes to the financial world, not everyone understands the intricacies that go into its daily operations. Even though the markets close every afternoon, the financial never really closes down. There are still moving parts around the clock that keep our money, investments, portfolios, assets and other property moving forward. Free Market Portfolio Theory is part of the power of three principle from Mark Matson, which means it has three components.


Efficient Market Hypothesis


One of the most important components of the Free Market Portfolio Theory was first explained in 1965 by Eugene F. Fama in his doctoral thesis and is known as the Efficient Market Hypothesis. Fama’s doctoral thesis stated the following: “In an efficient market, at any point in time, the actual price of a security will be a good estimate of its intrinsic value.” The sad part of the world today is that many people believe the stock market is inefficient, largely in part due to the behavior of the stock market itself as well as the media, popular culture and other factors.


Modern Portfolio Theory


The second aspect of Free Market Portfolio Theory is Modern Portfolio Theory. Harry Markowitz, Merton Miller and William Sharpe won the 1990 Nobel Prize for their collective work known as Modern Portfolio Theory. In short, Modern Portfolio Theory shows us that diversification may allow for the same portfolio expected return with reduced risk.


Three-Factor Model


The third and final component of the Free Market Portfolio Theory is the three-factor model. Professors Eugene Fama and Kenneth French conducted a study in 1991 that found when you expose a portfolio to three simple, yet diverse risk factors, you can determine the majority of results. The three factors include the market factor, the size effect and the value effect.


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