Risk Management

The job of the free market is to set prices so that investors are compensated for the risk they bear. Investors should be confident that every future period (day, month, year, 5, or 10 years), has approximately the same expected return (Er) for that period, given a certain investment (i). In other words, for each investment there is some probability distribution of future returns, where the average or mean of that distribution is the expected return. The expected return and standard deviation for diversified portfolios can be best estimated by looking at the last 50 years or using the Fama/French Five Factor Model for equities and fixed income, as explained here.

Market prices change so that buyers will be comfortable that they will earn the expected rate of return commensurate with the risk of their investment, based on the current estimated uncertainty of getting that expected return over the appropriate time horizon.

Investors should assume that the expected return is essentially constant based on the Five Factor Model or a long term (approximately 50 years) historical annualized return and standard deviation of a given investment, regardless of market conditions. The expected return changes very slightly as we add one data point at the end and drop one data point from the front of the historical data, to get the new average or annualized return and standard deviation.

Stated as a formula, the Current Price of an Investment (Pi) equals the current Expected Return (Eri) divided by the market's assessment of the current Uncertainty of that Expected Return (UEri), which we now call the Hebner Model:

The Hebner Model
Price (Pi) is expressed in currency ($), Er in % Return/Period of Time with an implied Standard Deviation based on your method of determination and UEri is a calculated index number with no units. Depending on your Price and Expected Return, you may want to multiply Uncertainty by 100 or some constant for charting purposes, see charts below.

Risk is actually represented twice in the model, with a certain level of risk embedded in the investment (such as Index Portfolio 50) and an additional layer of risk represented by current news or the Uncertainty of the Expected Return. In a really simplied version and a liberal interpretation of the terms, you could say that:

Price = Return/Risk
Risk = Return/Price and
Return = Price x Risk

To visualize how markets work, imagine an essentially constant Expected Return (Er) for a given investment portfolio set at the fulcrum of this teeter-totter. The Uncertainty of the Expected Return would be on the left side and the Price would be on the right side. The price is moving inversely proportional to the uncertainty of expected returns. When uncertainty (guided by unexpected and random new information about the systematic or market risk, i.e. news about capitalism) goes up 2%, prices (set by willing sellers agreeing with willing buyers in a free market) go down 2%. When uncertainty goes down 2%, the prices go up 2%, allowing expected return of the investment to remain essentially constant.

Market Forces - News Equilibrium = Expected Return / Price

The price agreed to by willing buyers and sellers embeds the expected return and the uncertainty of it for that moment in time. For this reason, investors can expect to be properly compensated for the risks they accept, every day they buy, regardless of price or market conditions because a free market reaches a price that is an equilibrium point between the two factors. Don't forget that the greater the risk, or volatility, of the investment, the longer the investor should be prepared to wait to achieve their annualized expected return. It is time, not timing that will determine your investing success.