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Golden Years Financial

GYF Free Market Philosophy

GYF Free Market Philosophy

At Golden Years Financial (GYF), we believe in living our personal and economic lives consistent with the principles in which we believe.   Often people live without guiding principles and wonder why the outcomes of their lives differ from their expectations – and isn’t it true that “unmet expectations” are the primary cause of disappointments in life?

It’s therefore important we clarify our guiding principles and increasingly align our lives therewith.   For example, do you believe that free market economies work?  Or are you an advocate of planned economies?   We, for example, believe one of the most vivid lessons of the 20th century is the visible failure of planned (or “centralized”) economies.   In short, we believe that capitalism has been the engine for the greatest freedom, innovation, and quality of life known to mankind.  While it, like any system, has its problems, those problems are infinitely less than what individuals in centrally-planned economies have experienced.  (Venezuela is a powerful example of this.  It’s one of the most resource-rich countries in the world, yet when we consider its currently prevailing political and economic belief system we see the failure of centralized-planning and the devastation system has inflicted on its subject-participants.)   At GYF, we believe Free Markets work!

In the investment world, there are parallels to free market and “actively-managed” systems.   Those who believe in “active management” believe humans can research stock-and-bond market opportunities and calculate when and what to buy or sell in a manner and sequence that brings extra rewards.  Conversely, Free Market Advocates (FMA) don’t believe human beings, with their inherent limitations, can consistently “out-perform” the market’s natural returns.  Consequently, FMAs believe in realizing the natural returns of the stock market by investing in all known asset classes in a structured fashion.  In this manner, investors are certain to realize whatever declines and gains are naturally occurring within the marketplace (i.e. the market’s natural returns.)  FMAs believe a vast amount of research exists that evidences “active management” does not consistently – and that’s the key word – outperform comparative market benchmarks.  In fact, active managers generally underperform “the market” while imposing additional fees on investors.

In an increasingly interconnected global economy where trillions of economic decisions are made each day, FMAs believe no mortal (or team thereof) can comprehend all of that simultaneously.   Instead, only the “invisible hand of the market” can accomplish this, as described by Adam Smith, the “Father of Economics” in his classic book of 1776.

At GYF, we believe in three specific principles that guide our investment behavior.  The first is “The Efficient Market Hypothesis” as described by Eugene Fama in his doctoral thesis of 1965 and, partly, for which he recently received the Nobel Prize.  It basically states . . .

  1. the natural forces of supply and demand are the best determinant of a stock’s inherent value and price and, consequently, “the actual price of a security will be a good estimate of its intrinsic value.”;
  2. all available information is included in the current price and, therefore, only unknowable (i.e. new) information can change pricing; and,
  3. finite humans are incapable of consistently predicting positive or negative market movements and, thereby, capturing additional returns unrelated to risk.

Dr. Fama’s research conflicts with the prevalent beliefs of Wall Street, the media, and popular culture generally, which assert that the market is inefficient and that enlightened investors (aka “money managers”) can consistently capitalize on these inefficiencies to outperform the market itself.

FMAs also embrace a second principle: “Modern Portfolio Theory” (MPT) for which Harry Markowitz, Merton Miller, and Myron Scholes won the Nobel Prize in 1990.  MPT basically states the risk of an individual asset is far less important than that asset’s contribution to the portfolio as a whole and that prudent diversification can result in increased returns without proportionally increasing risk.  Therefore, the goal of MPT advocates is to identify and combine of assets with dissimilar price movements (i.e. “low correlation”).  MPT further states that returns can be maximized for a given level of volatility, thus allowing investors to design a portfolio with the greatest efficiency in balancing their preferred level of volatility against expected returns.

The third principle is the “Three-Factor Model”, as presented by Eugene Fama and Kenneth French, which defines different dimensions of returns related to stocks (i.e. “equities”):

  1. the “Market Factor” that rewards stocks over bonds (or “fixed income” investments);
  2. the “Size Effect” that rewards small companies over larger-companies; and,
  3. the “Value Effect” that rewards high book-to-market over low book-to-market stocks (in other words, value companies traditionally generate greater returns than growth-oriented companies).

While no man-made model can fully explain the market in its entirety, FMAs believe these three principles are empirically-validated and intuitively sound and we, consequently, invest accordingly.  We also invite others to identify their fundamental beliefs and then align their actions accordingly.

Finally, we at GYF believe in focusing on the natural returns of the market and not chasing illusory returns.  We believe this is best accomplished by accessing known asset classes in an extremely-diversified manner designed to “eliminate stock picking, track record investing, and market timing from the investment process.”*   This is best accomplished by combining “uncorrelated” asset classes via asset-class funds that do not attempt to predict the future.  Structuring portfolios consistent with Modern Portfolio Theory thereby creates efficiencies and reduces trading cost.    

In short, we believe in buying a globally-diversified portfolio of stocks comprised of uncorrelated asset classes and then re-balancing that portfolio on a regular basis to maintain preferred levels of volatility and potential rewards.

*This article and GYF’s beliefs have been heavily influenced by Matson Money, Inc. and its educational systems.



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