Alan Cring Productions in association with Emergent Light Studio presents
the Illinois State Collegiate Compendium academic lectures in Business and Economics.
This is Business Finance FIL 190 for spring semester 2024.
Today the capital asset pricing model. This one is considered in some ways the triumph of finance
and if you are thinking of getting a tattoo you can't go wrong with getting the cap M tattooed
on your side or your thigh or something like that because it is a sign that you really have crossed
over into finance and I'll say more about it after a bit here and go through the last part of risk
and return. On Wednesday you will have a surprise quiz so please be surprised by it. It will primarily
cover bonds and those kinds of subjects but it will cross into a little bit of the first lecture
in risk and return as well. It won't be a terrible kind of quiz but do make sure that you are able to
use that template that I gave you for finding bond prices and bond yields. As I said that is the
important mathematical thing, things that you should be able to do out of that chapter on bonds
and of course there's qualitative stuff too. A quick look at the numbers though and as you can see
this is a bare day trying to find some reason not to be. You see that we opened down and even after
the opening it's still dropped. If you can see those spark charts you can see that it dropped
after the bell, at the bell it was already down and it kept going down for about I think it was
about 10 minutes and then it's been sort of jagged trying to grovel its way back up from that
immediate loss that happened and it's really just a malaise in the market right now. Some negative
sentiment is in there. It's nothing massive, nothing major, no apocalypse but the traders are
a little on the sour side and we can talk more about that here in a little bit when I get back
into risk and return. Now crude oil as I had said it's got a new trading range from about 81 or
about 81 up to 87, 88 somewhere in there maybe 89 but it's on the downside of that and it broke
down below the base of that and then a quick of that new trading range and then it quickly recovered
from there although it's still not particularly dramatic. We're up there just above 81 working
our way up to 82 but it's nothing terrible or tragic and as you could probably have noticed the
price of gasoline as I said has already reflected this new higher trading range. We're seeing at
the pumps around here about 379 for the regular unleaded. Nothing catastrophic of course but it's
up there a little bit. Now interestingly gold is pushing the next neckline it has at $2,200 an ounce.
It's on an upswing and it's just that there are some who are moving their money out of other assets
and getting them into some gold right now. I wouldn't call it a flight to quality so much. You
see the bond market over here we have the bond yields pulling upward and that would mean prices
are falling there is selling of bonds and there is selling of stocks as well so that would probably
indicate that there is a little a modest flight to quality give from bought stocks to bonds from
bonds to gold. You're seeing that second stage of a flight to quality but it is certainly nothing
catastrophic happening right now. If I am reading the markets however there is globally at least in
the first world countries there is a movement to trim yields. The yields seem to be starting to fall
on the around the mark around the world right now. I mean now as in this minute so this may turn on
a dime and these yields may start to drop as investors move money out of gold out of money
markets and buy into the bond market. You do see some I can't really see from this spark chart and
I let me let me click on this see if I can see it in. Now you see that top out right there that
may be the first indication that the US Treasuries are going to follow the government instrument
debt instruments in other countries and start to tail downward here over the next couple of hours.
Hard to say though but it does look like there is a little bit of movement that we've hit our top
there on the yield. Okay now going on here Nikkei started out down it started crabbing and then it
sort of floated below its opening and then right at the close it really started to take a dump. It
was down a total of one 1.16 percent for the day that last little thing there that was the bears
coming in right at the end of the day in Tokyo last night here and taking a real shot at it. Now
London it started falling it just started dropping and but right about midday it started to turn back
up like our markets are now they're not finished for the day yet in London as I've said they've
still got an hour or so left I think on their trading but it's noticeable that they are in a
recovery there the FTSE 100 is and well it's kind of hard to say we were in a recovery and now it's
turning back down the other way. Just a lot of bad sentiment going on right now it's not horrible
but it's just a grouchy day today. Let me take you on a journey here for just a little bit and this
is for the most part it's terminology and then it turns into something more and as I had said
yeah that's what I want. Now the measures of risk there is of course is the standard deviation
which is one over for the for a sample and one over n minus one times the sum from i equals 1
to n of the each data point minus the average squared. Now that's squared let me say something
about that you may have already heard this before why do we square that and then take the square root
of everything afterwards and which I didn't do there so let me get that done here. Why don't we
square it and then take the square root? Simple because some returns are going to some data points
are going to be below the average and some are going to be above the average. If we don't square
it then those below and above will cancel each other out and we will not see what really happened
as far as volatility both ways go. So we square them so that they're all positive and then we
correct it after we've added them them all up with by taking the square root and that of course is
our overall way of determining risk. Now this standard deviation sigma or in more technical terms
it's we call it s we reserve sigma for the population but one way or the other this is
actually the one that is used in corporate finance. If you took a course from me for example in
corporate finance finance where I'm looking at variation in revenues or variations in cost the
risk the risks inherent in your fixed costs the risks inherent in your variable costs the risks
inherent in your profit and all of that. We use this animal right here to do that more specifically
we probably use the coefficient of variation. The coefficient of variation CV is the standard
deviation divided by the average which takes away the scale the size of the numbers so that we can
compare for example fixed cost might be very large compared to variable cost or vice versa. When you
use the CV it corrects for those differences in size so you get a pure measure of the relative
risk levels of the different lines on your accounting statement or on your managerial
accounting sheets. That's all that is and it's very useful even for us it's useful too but our big
800 pound gorilla is always beta. Now the beta I'm going to write this down I want to talk about
this a little later and I'll show you where you could actually do this. The beta let's say of a
stock is the Pearson correlation coefficient of that stock with the market portfolio times the
standard deviation of the stock over the standard deviation of the market portfolio. That's how we
get betas and you can calculate them they're not that hard to calculate. Now yours would probably
be off a little bit or maybe a little more than a little bit because technically and I said this
last time in Wednesday's lecture the beta you're supposed to use expected returns and expected
standard deviations but mostly we're going we would be working with historical data so there
would be a difference between what you see and what some big reporting service would show because
it could do the crunching to get expected numbers instead of from the historical numbers. Anyway
that one's there too. Another measure of risk and I kind of dismissed this one but it does have a
useful part to it. The Sharpe ratio which is the return to your stock or portfolio minus the risk
free rate over the standard deviation. In fact I've got a sheet that you'll be able to pull up later
a risk and return sheet where it will do the Sharpe ratio it's just a one of the calculations
that it does when you put in data. Now the Sharpe ratio as I said okay here's the big
criticism of Sharpe. Sharpe uses a standard deviation as the metric of risk instead of
beta as a metric of risk. I don't know it's just been around forever and it's almost always if
you look at a mutual fund they'll report the Sharpe ratio it's easier to find the Sharpe ratio
in the reporting than it is the beta sometimes. It's a number and it's kind of a it's a big thing
here. Let me show you something here. Now there's something that's on the side here and I can turn
let me turn off these lights so you can see a little better in here but R minus R sub F. The book,
later it says it the way I say it but at first they call this the risk premium. The risk premium.
Later, technically what we call this is the market premium over risk-free.
You'll hear me call it the market premium. The market premium over the risk-free rate and you
would do this for a stock like that. Here's what it's telling you. You can go risk-free anytime
you want. You look like a very timid fearful investor. A man who would never take a chance
on anything. When they say would you like to have corn flakes or grape nuts you say I don't go and
get it over my head I'll have the corn flakes. You're the guy who drives at 25 miles an hour
on the Autobahn as cars try to go around you and they take off your the sides of your car and their
wins here. Okay you're the guy who did not want to go to college because you could go right out and
get a job at $8 an hour. No risk of college for you but if you had gone to college you would have
made $50 an hour. So there's a risk premium that you would realize by bearing risk instead of bearing
no risk. So in other words this thing this animal right here and would be if I write it this way R
sub M minus R sub F. This is the market premium. That's the market premium. So in other words if
we expect the return to the market this year to be 16% and the risk-free rate is 4% then the market
premium over risk-free is going to be 12%. This is your reward for bearing the risk of the market
portfolio. This is your reward for bearing the risk of the market portfolio and that is hugely
important to us because if you take beta of a stock times R sub M minus R sub F. Beta is what
magnifies or demagnifies the market premium that you will realize. So in other words if I took a
beta let's take a couple let's say beta 1 is 1.00 that would mean that you would have 1.00 times
16% minus 4%. So you would earn exactly your your premium for the risk that you took at a 1.00 beta
would be exactly the market return. If however let's say that you decided that you were going
to take 1.5 beta then you would be have 1.50 times 16% minus 4% which would be 18%. That would be
what you would earn because the beta has magnified the market premium. Suppose instead that you took
a beta of 0.5 that would mean which would be 6%. You take half of the market risk you get half of
the markets reward. Now one special one here suppose that you did not want to take any risk
beta 4 I'm sorry I'm writing these all over the board here these tiny little boards they have here
beta sub 4 is 0.00 in other words you want something that has no beta risk. Well in that
case you would have 0.00 times 16% minus 4%. You would get no reward for bearing any of the
market risk. Now that doesn't mean you won't get a reward that's where CAPM comes in but as far as
market driven risk you get none. That's all the beta is. Beta is nothing but a magnifier or
demagnifier on the market premium. Beta is nothing but a magnifier or a demagnifier on the market
premium. See the market premium is 12%. Beta is going to either magnify it or demagnify it.
That's all beta does. But this is driven by the markets conditions. So as the expected return to
the market portfolio changes or as the risk-free rate changes then this magnification or
demagnification is on a different number. Let me take this off the board here just put it together.
We start with a premise here. No investment would give you less than the risk-free rate. Because
suppose I'm going to give you an investment sir that is risky as hell but you can and you will
earn just what you would get on a Treasury bill that has no risk. Well you'll say kiss my ass I'm
not going to do that I'll just take the Treasury bill. Okay I can give you ten dollars to walk out
that door on the first floor or I can give you ten dollars to jump off the fourth floor balcony
outside there. Either way you get ten dollars which one are you going to take? No because he'll be
sued by the squirrely lands on those fat ass squirrels out there. The damn beggars walk up to
you and can I please have something for? Get away from me you fat ass squirrel. Anyway but what I'm
trying to get to here is that there's not going to be in a reasonable world any investment that
would pay you below the risk-free rate. And so we could say well what did that mean for the expected
return to a stock? Well the first thing it would mean is that you would earn the risk-free rate
you would earn it because no investment is going to give you less than that because you would just
go over and buy Treasuries if that happened. And then in addition to that you will get the market
premium times the magnifier the beta. That mother right there is called the capital asset pricing
model the capital asset pricing model the CAPM. This is what I was telling you about at the
beginning if you're going to get a tattoo you cannot get wrong with this one. Large font times
new Roman maybe just for the tastefulness of it. There you go. That is this now a little bit of a
historical background on this just to make sure you know where where we are. There are competing
models. There's one called APT the arbitrage pricing model. It's basically this one but it
says that there are different betas attached to an investment and you would have to add in and I'm
going to just write this here. Like this one might be the traditional beta and then there might be
another beta times market premium and there might be another beta times the market premium. There
might be a whole series of them. That's APT arbitrage pricing model but you know what many
many studies have been done and most of them find out that worrying about these other weird-ass
betas they don't do any better predicting return than the classic CAPM does. They really don't.
Now we're always looking for another a better way because CAPM isn't perfect obviously. The
expected return you calculate and what actually happens you know they can deviate. I'm going to
talk about that in a minute that it's a very cool place to look but realistically speaking
this works and in fact interestingly enough well let me go into this. I'll go into this. Graphically
if I were to use this as the y and the beta as the x so on the horizontal axis we have beta on
the vertical axis we have the expected return. Well the first thing we would know let's say so
if on this axis here's 1.00 for beta I'm doing 0.2 increments here then we would know that a
beta of 1 will yield the expected return to the market portfolio. Well that's what a beta of 1
means. That's why we call it beta of 1. We also know that a beta of 0 would get us the risk-free
rate R sub F. If you have no if the it's a risk-free interest instrument then we expect it to pay the
risk-free rate. Now if you remember from linear your linear algebra two points create a line.
This is the cap M graphically beta plotted against expected return. We call this line the securities
market line. And it's just a plot so I could say well what would be a beta of 0.6 that's right
here should be there. Beta of 1.5 should be right here. It's just a visual representation of cap M.
But it has some interesting uses. First things first and this is my traditional rant from hell.
We even have a contest we did I don't know if they're still running it but you see all of these
talking heads. Well this fund manager got the highest return this year. Boy that guy's a real
excellent son of a bitch yes indeed. We give out awards we had their contests all over the country
and we had one here. The team that gets the highest return wins. It's two-dimensional they
completely ignore what risk was taken. Yeah I can be a hero I can get a damn return clear up here
about where Jesus lives but you are going to take a massive risk to do that appropriateness of
investment. You're sure you can be I a matter of fact this was 2-3 41 maybe about six years ago.
I had teens make portfolios and I said okay choose wisely and get it done great get a good
return on it and I told them what I would expect them to get based upon cap M. Report cap M report
what the expected return is and then at the end of the semester report what your return is. Okay
so in other words you got to hit cap M. Well this one group they came in about two weeks before the
end of the semester and they'd been working their beta was all over the place they were adding
things pulling things out and I couldn't even figure out where the hell it was the beta but
their return was negative eight percent about no negative seven percent and they said so basically
we're screwed and I said what do you do? Have any of you ever was old college football term have any
of you ever heard of the Hail Mary in football? You're clear back near your own goal line and
the Hail Mary is that pass clear down the field fourth and 15 and you've just Hail Mary to throw
it clear down the field and hope one of your guys catches it down there. Said you can do a Hail Mary
liquidate the portfolio and just throw it into the highest beta thing you can find because I
mean theoretically you put a bait out there at least two weeks you're going to have a return
up there maybe well I'll be darned if they did and they came out pretty well I mean of course that
was also a portfolio that could have crashed and burned them so that they would have not passed my
course and matter of fact they probably couldn't have gotten a job at ace trucking Scott gotten his
scholarship at ace trucking school okay but yeah you can I mean all this is doing is telling you
look what do you expect to return based upon the beta but that's the important thing is that there's
no such thing as a an expected return or a return to a portfolio it is always attached to a risk
variable somewhere in there but here's the interesting thing we actual analysis puts the
portfolios the real portfolios all around it now we have some anomalous portfolios it's more like
it's not the real world doesn't lie on a perfect line it's a lies on a scatterplot so the world
doesn't really oh god this is a cap M we better get these returns right there now it'll be around
that now that we do see a few anomalies and it's the stuff of research papers and all that like
for example there are there's an anomaly called the January effect where there are certain stocks
classes classes of stocks that seem to violate cap M there's another one called a small cap
phenomenon where certain types of small capitalization stocks seem to seem to come in above the
securities market line however there's a more enduring phenomenon and you might actually be
part of that not know it see most day traders and amateur investors lose money I in real terms or
in terms of opportunity cost of the time and capital they put into doing day trading they lose
it but every now and then we see a trader we see someone who routinely gets a return above the
securities market line of course we see plenty of traders who are below it you see right here this
trader above he is earning an abnormal return and it's not just a one-off this it wasn't a
one-trick pony this one keeps staying above it we have a name for this distance right here from
where cap M says he should earn or she and where he or she does earn we call that Jensen's alpha
Jensen's alpha as a matter of fact there's a famous and very good website called seeking
alpha have any of you ever heard of it what you're doing is a play for those who know what alpha is
Jensen's alpha so of course trading house they're going to get free accounts because all we need to
do is find you mr. genius and then we watch what you invest in and then we front run you you know
what front running is no in front of you you say I want to put in this trade for this stock and a
split second before we execute your trade we execute ours for what you did that's front running
it's illegal okay but yeah we're looking for the pause we're seeking alphas yeah I get yours and
you're going to go okay I got to watch how I say this you see there used to be a system called
SOES small order entry system so that small orders got in first before large orders it was
just a NASDAQ thing okay and they've changed it it's got a different name now I don't remember
what the name is now but that's still the way it is so I as an insider in order to take advantage
of this I cannot put in a big block trade what I'll do is I'll have a hundred a thousand phony
shadow accounts each one will be a small order entry system I just have those happen and then a
split second later I execute your order matter of fact the algo is simply okay this is one of our
alphas this is an alpha trade and so the alpha will will electronically put in a mass order
through the that each one of them will be small but they'll get through the SOES system and then
yours will come in towards the back door of the other ones they'll muscle you out of the way and
get theirs in you think it doesn't happen happens all the time we're always looking for it it was
like up in Chicagoland I took my suits up to the White Sox so they could learn about finance at
the White Sox and what they were we so they maybe get jobs there's something like that and they were
we were at we were hosted by the White Sox charitable organization they spend a lot of
money every summer setting up and funding Little League teams through Chicagoland hundreds and
hundreds of Little League teams now do you think that they do this out of the beneficence of their
hearts no all it takes is finding one little snot-nosed kid nine years old who's got an arm
that just won't quit or one that knows how to hustle bases faster than anyone else or someone
who just happens to be just unbelievable with that bat three four of those out of five thousand ten
thousand kids and you have won your investment it's the same thing it's the same idea you're
a charitable person but you're always looking for that winner and then you can milk that winner you
find that kid you go to his family we're going to take care of you now we'll make sure you have a
good place to live you've got food on the table and we're going to make sure that kid gets his
school school work done we'll have tutors we'll do the whole damn nine yards for that kid if you
will sign us with an option for that kid down the road for it for us to get him into the
farm league a little later these are the kinds of things that happen okay and in trading we are
always seeking alphas so are you know you hear about well she's an alpha male now we're looking
for a completely different kind we're looking for the nerd the geek that just happens to have the
magic we don't know why they have it hell they might use magic mushrooms we don't care but at
the same time we're always looking for those players the ones that just seem to have a magic
I was a casino when it back many many many years ago there was once in a while you see some son of
a bitch he could not lose and of course I was getting poorer and poorer the more I paid 20
played on the 21 table or something like that but that son of a bitch he just kept winning and it's
a magic but anyway okay so that's an alpha that's a positive but don't get me wrong this guy down
here that's a negative alpha so we're always looking for the alpha and as long as you stay
at least alpha zero or a little bit above alpha zero you are actually beating the market the term
beating the market is misused oh he got higher than the market portfolio so I beat the market
no he just went out here hi see this is the return to the market portfolio sure you can beat that by
just taking a higher beta on your portfolio but actually beating the market portfolio really
means at that level of beta of your portfolio what did you do did you get above cap M did you get a
positive alpha that is beating the market one more thing about that if I see one of you getting a
positive alpha I know it's genuine and I also know that you probably won't do it again if you do I
want to be your friend for life but I mean an out positive alpha for one year or for a couple of
months it usually vanishes it's the enduring positive alpha that is a mark of a truly good
small-time investor when I see a large investor who's constantly getting a positive alpha I
smell a rat I smell insider insider trading that's all there is to it because the reality is that
having a positive alpha you either have to have a gift or you have to have some kind of insider
information that's just the reality of it I'm not gonna bullshit you about that you're someone well
I beat the market every year okay first of all that means is that you took a high beta portfolio
no no no it was at that beta I got a positive alpha every year okay exactly how are you doing
this because the market if I identify you sir as having a positive alpha year after year I'm going
to start trading in front of you and I'll suck your profit away you think the price stock price
is going to go up to ten dollars well I'll make sure I buy into and drive it up to ten before your
order ever gets traded so you will lose that gift because everyone will figure out what you're doing
and because you signal it when you do the buy order or the sell order you're signaling to the
market here I am and then everyone's going to come in there and take your mojo now a couple of
things here first of all the return to your portfolio I mean this is kind of like stupid
pet trick stuff weight of poor of portfolio of stock one times the return to talk sock one plus
the weight of sock two times the return to sock two plus the weight of sock and times the return
to stock and okay it's nothing hard you can just put it the return to the portfolio is the sum from
i equals one to n of the weights of the individual components times the return to the individual
components just take the weight times the return add them up some product on excel and you're there
that's your dinner yeah however well let's get that one down I saw some look look at hers but
one of the things about that is that the betas are a little bit suspect that she had those are
high beta stocks another a really great example was a former senator matter of fact I think her
niece is running for a congressional seat here in Illinois somewhere but she was had was in the
secret meetings when the before the coat before the covert pandemic was known to the outside world
and she unquestionably traded on vaccine stocks more importantly her husband is the chairman and
owner of the New York Stock Exchange he did too they are untouchable there's no question that they
were using secret information to trade in to take a profit to make money off the off the pandemic
there were others we've count probably five representatives and one senator clearly and of
course they're going to say we don't control our portfolios we have it all done through a
blind trust and a portfolio manager well they have something called a telephone and they probably
called the portfolio manager said get that hell into mrna moderna get your the hell into Pfizer
pfe get yourself into AstraZeneca and get the hell out of this this this and this that's all it
takes and of course politics that's which is why I always thought I should run for pop for a
political position I mean I've got hell I got the damn charm for it but aside from that yeah
yeah and that's why you want to watch those sons of bitches as closely as you can there are reporting
services of report on insider trading that's just the CEOs and the C-suite people doing buys and
sells keeping an eye on those giant dogs like that hard as hell because they hide under privacy laws
they use private trusts and you can't see it until their financial disclosures and so by then of
course it's too late to know what they're doing we have some tricks in the book to watch
well if you're obsessed with her I mean she's pretty old for a guy your age but you know I
mean don't get it don't get into this obsession that it's one political party the Republicans
were the ones who played that game with the kovat virus only one Democrat and he's a dumbass
and but at the same time and it's not just politicians don't get me wrong a lot of the
wealthiest people in the world I mean Elon Musk and his brother were insider trading there's no
question about it they've been chased around and around by the SEC on their insider trading
they'll never burn them now if you do it mr. cousins you will be caught and you will be made
into some hard timers old lady with a full wedding ceremony for ten years us at the bottom of the
level if we do anything wrong even if we fart sideways out of our butts we're nailed the big
dogs are hardly ever once in a while they'll make an example of a whale but for the reality of it
finra is for us little people and that's just reality of it and they've had a finra representative
here and I cooked her on the law floor and so I'm not invited to have to go to those again but
anyway let me get on to something else here let me get on to something else here on this oh by the
way the beta of a portfolio is the same thing the beta of a portfolio is nothing but the sum from
i equals 1 to n of the weight of each stock in the portfolio times the beta of that stock you just
take the weights on the beta and add them up and that's an important one to know because that gives
you what the overall beta of your portfolio is now let me go back here though and talk about a
lonely little animal called the Pearson correlation coefficient you see a stock has two kinds of risk
as I said there is the total risk is the diversifiable risk the risk that can be removed
through portfolio diversification plus the non diversifiable risk well the non diversifiable
risk is beta your job is to make that diversifiable risk go away and that is that risk
pooling that I told you about on Wednesday the more you put in the more the kinks in each the
standalone risk goes away so if you were to make your own portfolio let me show you over here
number of stocks on the horizontal axis and the total risk of the portfolio here if you have one
stock in a portfolio you eat the risk of that stock both the diversifiable and the non diversifiable
I think I already said it you buy Microsoft on its own that beta represents only about 40% of what
you're going to face as far as volatility goes buying single stock is insane you're not going to
get rewarded for something that you don't have to do you're not going to get any reward at all only
for the diverse fought non diverse fibers but as you put in more and more stocks into a portfolio
the non diverse the diversifiable risk component goes away and you ask them tonically approach the
non diversifiable risk how many does it take 95% of the diverse viable risk will be gone with about
35 stocks that's a bad thing though because you have to manage a 35 stock portfolio that's
expensive and it's time-consuming because you've got to be constantly balancing the portfolio or
you could buy an ETF the spider the S&P 500 spider SPY
that son of a bitch has 500 stocks and you buy one share of that and you have the portfolio
diversification of the S&P 500 in fact it is so well diversified that we use it as a proxy for
the market portfolio because it's got so many stocks in it but here's the thing suppose that
you want to build a portfolio and you go buy 35 stocks that's what you need to do is find
stocks that have low correlation against each other so that when one's going up the other's
going down and they are canceling out each other's standalone risk so how do we do that how do we
find those well there is a wonderful place called asset the portfolio visualizer I can type in
stocks and see what their correlation coefficients are so let me do that right now let's try
Walmart WMT put a space oh I don't know meta is meta METE I thought I think it'll tell me
I'm wrong let's try General Motors Tesla Pfizer give me give me some guidance here what else
Apple oh a APL Lockheed Martin what is MA is it MA yeah let's do these now you can leave these
alone you can be a little fancier if you want now what you get is a correlation matrix now you may
have did they show well I keep forgetting you probably aren't fully through stats this shows
each one against its counterparts so for example Walmart against Walmart has a perfect correlation
1.00 here's my rule and you can do others will say different things my rule rule is no more than
point 3l no more so I look over here Walmart and meta they would be great in a portfolio together
because they're canceling out a lot they they're very poorly correlated at point one two Walmart
against GM is great against Tesla against Pfizer now here's one right on the edge Walmart against
Apple their points 3l that's right about I mean I don't even need to do that because I've got so
many already Walmart and against MasterCard Walmart is actually one that would be good in any
portfolio that would be sore what we call one of our keys for our portfolio would be a Walmart
because it seems to be correlated with almost nothing now let's look at meta now this is
symmetric about the diagonal so we'll go to meta we'll look at meta against GM yeah that's too bad
test it's against Tesla not bad oh look at meta against MasterCard point three six now sometimes
it's obvious why they're highly correlated and other times it's like WTF what you know hot why
but here it is they would not be good in a portfolio together because they're not doing
as much as other stocks would do look at General Motors come over here aha well obviously against
Tesla it's about point 3l Pfizer yeah now that one would be why is General Motors have a nasty
correlation with Apple who knows but against Lockheed Martin a defense industry company low
but General Motors against MasterCard I know why General Motors credit they are subject to exposure
of risks in the same credit extending industry that one's okay I got it Tesla against Pfizer I
mean there's so it's obvious point zero six yeah sure but against Apple what and against Lockheed
Martin oh that's a nice nice one point zero one MasterCard point two four not bad okay I'm going
down here to Pfizer Pfizer against Apple and decent now that one Pfizer against Lockheed Martin
what Lockheed Martin builds defense stuff and people get injured and Pfizer's medical stuff
they give to them I don't know this MasterCard not bad Apple against Lockheed Martin who look
at that Apple against MasterCard the hell oh they both they have credit facilities Lockheed Martin
against MasterCard I got nothing I got nothing on that nope but do you see but do you see how
this correlation matrix if for one thing I see right here Walmart is a key component of a portfolio
because it's insensitive against almost everything and other ones that aren't too bad Tesla it's got
a couple that worries me but I don't know Meta it's it's pretty good too against a lot of stuff
except MasterCard you can go down the list here and you can see and you can type in your own
symbols and before you decide to jump into a stock look at how it's correlated against something you
already have use this portfolio visualizer it's just a great free tool it's been around for a
long long long time and even my former students who are out there in the equities world they'll
go back to and look at it when they're thinking of throwing in an investment because the last
thing you want to do is put in two investments that feed each other's volatility you want them
to cancel out each other's volatility and so you can get close faster down to that not your
portfolio has nothing but non diversifiable risk in it kind of thing and you're never going to get
there all the way but I will tell you a couple of one one little trick here along the way and this
is something that I usually reserve for my 242 class investments let me show you something here
I used to do this as part of the lectures and any more I don't but I'll show it to you on as a side
hustle this you can do this on Google the word the term that I'm going to show you and you can see
this over and over again if we were going to draw risk total rest in an deviation against expected
return against return let's just do returns to different stocks and portfolios now this has been
done so many times it's ridiculous and you'll see if you Google after I tell you the word let's take
oh Microsoft its total risk and its return its risk as standard deviation or coefficient variation
you could do take some other stocks with higher risk take some little portfolios and big portfolios
high risk low risk now these scatter plots as I said they are the stuff of dissertations from long
ago when we were still a little amazed at what we were seeing taking higher risk and the returns to
different portfolios of stocks bonds stocks and bonds little portfolios big portfolios and over
and over what happens is that we get scatter plots and now with computers they can do this in the
blink of an eye we see something emerge that comes from the world of physics and chemistry is it also
in the world of kinesiology it's in the world of engineering mechanical engineering electrical
engineering it's a principle of the universe no matter how many points we plot there is a place
where on the other side of it it's white space we never see anything up in here the term in
mathematics for it and in engineering and physics is envelope it's a performance envelope we see it
you decide that you're going to become a beefy muscle builder you know you start playing the
rocky music every morning ba ba ba ba ba ba ba ba ba ba have you ever seen the original rocky movie
I thought as a kid I wanted to do that every morning he got up and he put five eggs in a glass
and he drank them well I thought I was going to do that now that was that first time I did that that
was when I realized what the term debris field means I mean down it went and then up it came but
anyway but no matter how hard you try there's a point of weight level you cannot cross no matter
what you do there is you've hit your envelope no matter how much you tweak your car there is a
speed that you cannot get above no matter where we go in the universe there is a size of a star
that is the limit we do not see one larger than that limit no matter how much power you put into
an engine the speed of light is the barrier you can't cross it that's why we have to do tricks
we're working on these warp drives that can technically they don't break the speed of light
they just kind of squeeze space in front and stretch it in back but you see this envelope
right here we call it in finance the frontier of efficient investments the frontier of efficient
investments it cannot be crossed as a matter of fact if you type in Google a frontier of
efficient investments investments images you'll see pictures of this and odd weird variations
but you'll see this over matter of fact I've made one myself and it was on Google for years before
it was replaced by more recent pictures of it it's just that's where the end is now what would be on
that frontier well you see what would be on it would be market portfolios all of the stocks and
bonds in the world in different combinations but all of them those would be market portfolios it is
a theoretical boundary we can't reach it the S&P 500 is near it but it's not on it so let me show
you like let's say this is Microsoft stock it has that risk level and it has that return
we should be able to get that return with a perfect portfolio right there so in other words this is
all diversifiable risk only this part is beta risk because I could buy Microsoft but there's
also a portfolio that would get me the same return with less risk because I wouldn't have
that diversifiable risk in it now what does this mean you can't for example now okay here's here's
the one of the ways that you can get as close as possible you get it's called super portfolios what
you would do is you would get three very well diversified portfolios and you would put them
together and they would actually get you closer to the frontier I mean you're talking about in
millimeters but it actually is a portfolio management strategy you don't just buy the
spider you grab the spider and another highly diversified ETF and another highly diversified
ETF you just put three of these together and they'll squeeze out a little more of that non-diverse
that diversifiable risk but even if you just got the S&P 500 you're pretty darn close to the frontier
you can't get there that it's a theoretical place it's the envelope it's that weight that you'll
never achieve but you can get closer and closer the more you're willing to get horny is it's that
speed you can get closer and closer to it with your car but you can never quite get to that dream
speed in it this is all in explosives we can yield more and more thermal energy out of a bomb a given
chemical bomb but where's a certain place where we can't get any more explosive power out of it
it's just the way the universe works it sets limits on them and says get closer to me and that's
what we do a lot of time the portfolio management is we just get a couple of really well diversified
portfolios and we put the damn things together and the result of it is that we get the same we get
it the same expected return but a little less of that standalone risk as it were one of the things
we do and like I said I there are a couple other I'm reticent to use the word tricks there are other
ways that you can inch up to the frontier one of them believe it or not is to mix t-bills in and
if you take me for 341 if you're that lucky I'll even show you how you pull that stunt it's pretty
cool but this is the this is the introduction to finance that if before this you might have been a
day trader but here this is where we you're looking inside and now you're seeing the mechanics of the
flaws of physics and how they relate to what we do here in our subject that's all I have for you
today I thank you