Three Academic Investing Principles Successful Investors Use

When it comes to your investing, we have looked at three things to avoid doing, three things you should be doing, and three types of Wall Street bullies you should avoid.

Today, I want to introduce you to three academic investing principles that you can implement with your portfolio that are backed by science and research. These principles can help you become a successful investor.

The three principles are:

• Efficient Market Hypothesis
• Modern Portfolio Theory
• Three Factor Model

I will do my best to keep the explanations brief and understandable so you can begin using them. The efficient market hypothesis essentially states that the value of a company is reflected in its stock price at any given time. Also implied is that the market reacts so quickly with new and unforeseen events that it would be nearly impossible for anyone to use the new information in such a way to make money on any trading before the price changes.

An example of this would be when a particular airline has one of its planes crash. Let’s pretend you own this particular stock and based on this information you feel like you should sell the stock before the price drops as everyone expects it to do. By the time you call, email, or text your adviser, the stock has already dropped and now you won’t get as much for the sale of your stock as you would have if you sold it prior to the crash. The market simply reacts too quickly to capitalize on the information. This is a real life example of the Efficient Market Hypothesis.

Since the market moves so quickly, how would you best capture the returns? A Nobel Prize winner, Harry Markowitz, earned this award for his research on Modern Portfolio Theory. Essentially, this theory states that in order to capture the most amount of return while taking on the least amount of risk, you should invest in the parts of the market that move in different directions from each other.

For example, when stocks go up, bonds usually go down. Therefore to smooth out the ride in the market over time, it would be good to have both stocks and bonds in your portfolio. Also, stocks for US-based companies usually move in different ways as the stocks for international companies. And so on. Markowitz earned his Nobel for discovering this theory and proving it with his research.

Lastly, the Three Factor Model builds upon the Efficient Market Hypothesis and Modern Portfolio Theory. Nobel prize winner, Gene Fama, took Markowitz’s research to the next level. He identified other factors that added to the return while reducing the amount of risk investors would take on in their portfolios. In addition to the factor of being in the market (stocks) versus bonds or savings accounts, he discovered that small company stocks beat large company stocks and that value stocks would beat growth stocks over time.

Let’s put it all together.

The market reacts quickly enough that it is nearly impossible to capitalize on it once new information comes out. The best way to build a portfolio is by buying stocks and bonds that move differently from each other. The specific areas of the market to buy would include large stocks and small stocks (both US and international), growth and value stocks (both US and international AND both large and small).

When you look at your portfolio, do you see these categories? If not, or you are not sure, please contact us and we will analyze your portfolio to make sure you are set up as well as you can be to implement these academic investing principles.