1 00:00:00,000 --> 00:00:07,840 Alan Cring Productions in association with Emergent Light Studio presents 2 00:00:10,080 --> 00:00:16,000 the Illinois State Collegiate Compendium academic lectures in Business and Economics. 3 00:00:17,440 --> 00:00:23,360 This is Business Finance FIL 190 for spring semester 2024. 4 00:00:23,360 --> 00:00:39,200 Today the capital asset pricing model. This one is considered in some ways the triumph of finance 5 00:00:39,200 --> 00:00:46,760 and if you are thinking of getting a tattoo you can't go wrong with getting the cap M tattooed 6 00:00:46,760 --> 00:00:55,400 on your side or your thigh or something like that because it is a sign that you really have crossed 7 00:00:55,400 --> 00:01:04,680 over into finance and I'll say more about it after a bit here and go through the last part of risk 8 00:01:04,680 --> 00:01:12,920 and return. On Wednesday you will have a surprise quiz so please be surprised by it. It will primarily 9 00:01:12,920 --> 00:01:22,320 cover bonds and those kinds of subjects but it will cross into a little bit of the first lecture 10 00:01:22,320 --> 00:01:30,440 in risk and return as well. It won't be a terrible kind of quiz but do make sure that you are able to 11 00:01:30,440 --> 00:01:40,120 use that template that I gave you for finding bond prices and bond yields. As I said that is the 12 00:01:40,120 --> 00:01:49,240 important mathematical thing, things that you should be able to do out of that chapter on bonds 13 00:01:49,240 --> 00:01:59,400 and of course there's qualitative stuff too. A quick look at the numbers though and as you can see 14 00:02:00,520 --> 00:02:09,880 this is a bare day trying to find some reason not to be. You see that we opened down and even after 15 00:02:09,880 --> 00:02:15,560 the opening it's still dropped. If you can see those spark charts you can see that it dropped 16 00:02:15,560 --> 00:02:23,040 after the bell, at the bell it was already down and it kept going down for about I think it was 17 00:02:23,040 --> 00:02:31,640 about 10 minutes and then it's been sort of jagged trying to grovel its way back up from that 18 00:02:31,640 --> 00:02:41,800 immediate loss that happened and it's really just a malaise in the market right now. Some negative 19 00:02:41,800 --> 00:02:49,400 sentiment is in there. It's nothing massive, nothing major, no apocalypse but the traders are 20 00:02:49,400 --> 00:02:56,360 a little on the sour side and we can talk more about that here in a little bit when I get back 21 00:02:56,360 --> 00:03:06,040 into risk and return. Now crude oil as I had said it's got a new trading range from about 81 or 22 00:03:06,040 --> 00:03:15,600 about 81 up to 87, 88 somewhere in there maybe 89 but it's on the downside of that and it broke 23 00:03:15,600 --> 00:03:21,840 down below the base of that and then a quick of that new trading range and then it quickly recovered 24 00:03:21,840 --> 00:03:30,040 from there although it's still not particularly dramatic. We're up there just above 81 working 25 00:03:30,040 --> 00:03:36,800 our way up to 82 but it's nothing terrible or tragic and as you could probably have noticed the 26 00:03:36,800 --> 00:03:44,280 price of gasoline as I said has already reflected this new higher trading range. We're seeing at 27 00:03:44,280 --> 00:03:55,800 the pumps around here about 379 for the regular unleaded. Nothing catastrophic of course but it's 28 00:03:55,800 --> 00:04:06,520 up there a little bit. Now interestingly gold is pushing the next neckline it has at $2,200 an ounce. 29 00:04:06,520 --> 00:04:16,760 It's on an upswing and it's just that there are some who are moving their money out of other assets 30 00:04:16,760 --> 00:04:23,520 and getting them into some gold right now. I wouldn't call it a flight to quality so much. You 31 00:04:23,520 --> 00:04:30,680 see the bond market over here we have the bond yields pulling upward and that would mean prices 32 00:04:30,680 --> 00:04:38,800 are falling there is selling of bonds and there is selling of stocks as well so that would probably 33 00:04:38,800 --> 00:04:46,040 indicate that there is a little a modest flight to quality give from bought stocks to bonds from 34 00:04:46,040 --> 00:04:51,560 bonds to gold. You're seeing that second stage of a flight to quality but it is certainly nothing 35 00:04:51,560 --> 00:05:01,600 catastrophic happening right now. If I am reading the markets however there is globally at least in 36 00:05:01,600 --> 00:05:09,840 the first world countries there is a movement to trim yields. The yields seem to be starting to fall 37 00:05:09,840 --> 00:05:20,000 on the around the mark around the world right now. I mean now as in this minute so this may turn on 38 00:05:20,000 --> 00:05:26,960 a dime and these yields may start to drop as investors move money out of gold out of money 39 00:05:26,960 --> 00:05:33,440 markets and buy into the bond market. You do see some I can't really see from this spark chart and 40 00:05:33,440 --> 00:05:41,160 I let me let me click on this see if I can see it in. Now you see that top out right there that 41 00:05:41,160 --> 00:05:51,660 may be the first indication that the US Treasuries are going to follow the government instrument 42 00:05:51,660 --> 00:05:57,560 debt instruments in other countries and start to tail downward here over the next couple of hours. 43 00:05:57,560 --> 00:06:04,560 Hard to say though but it does look like there is a little bit of movement that we've hit our top 44 00:06:04,560 --> 00:06:16,120 there on the yield. Okay now going on here Nikkei started out down it started crabbing and then it 45 00:06:16,120 --> 00:06:23,440 sort of floated below its opening and then right at the close it really started to take a dump. It 46 00:06:23,440 --> 00:06:32,400 was down a total of one 1.16 percent for the day that last little thing there that was the bears 47 00:06:32,400 --> 00:06:40,680 coming in right at the end of the day in Tokyo last night here and taking a real shot at it. Now 48 00:06:40,680 --> 00:06:48,800 London it started falling it just started dropping and but right about midday it started to turn back 49 00:06:48,800 --> 00:06:54,320 up like our markets are now they're not finished for the day yet in London as I've said they've 50 00:06:54,320 --> 00:07:01,200 still got an hour or so left I think on their trading but it's noticeable that they are in a 51 00:07:01,200 --> 00:07:09,160 recovery there the FTSE 100 is and well it's kind of hard to say we were in a recovery and now it's 52 00:07:09,160 --> 00:07:16,200 turning back down the other way. Just a lot of bad sentiment going on right now it's not horrible 53 00:07:16,200 --> 00:07:24,760 but it's just a grouchy day today. Let me take you on a journey here for just a little bit and this 54 00:07:24,760 --> 00:07:36,040 is for the most part it's terminology and then it turns into something more and as I had said 55 00:07:36,040 --> 00:07:59,880 yeah that's what I want. Now the measures of risk there is of course is the standard deviation 56 00:07:59,880 --> 00:08:09,440 which is one over for the for a sample and one over n minus one times the sum from i equals 1 57 00:08:09,440 --> 00:08:19,960 to n of the each data point minus the average squared. Now that's squared let me say something 58 00:08:19,960 --> 00:08:25,680 about that you may have already heard this before why do we square that and then take the square root 59 00:08:25,680 --> 00:08:34,360 of everything afterwards and which I didn't do there so let me get that done here. Why don't we 60 00:08:34,360 --> 00:08:40,040 square it and then take the square root? Simple because some returns are going to some data points 61 00:08:40,040 --> 00:08:46,280 are going to be below the average and some are going to be above the average. If we don't square 62 00:08:46,280 --> 00:08:52,480 it then those below and above will cancel each other out and we will not see what really happened 63 00:08:52,480 --> 00:08:59,720 as far as volatility both ways go. So we square them so that they're all positive and then we 64 00:08:59,720 --> 00:09:08,360 correct it after we've added them them all up with by taking the square root and that of course is 65 00:09:08,360 --> 00:09:20,320 our overall way of determining risk. Now this standard deviation sigma or in more technical terms 66 00:09:20,320 --> 00:09:27,760 it's we call it s we reserve sigma for the population but one way or the other this is 67 00:09:27,760 --> 00:09:34,280 actually the one that is used in corporate finance. If you took a course from me for example in 68 00:09:34,280 --> 00:09:40,720 corporate finance finance where I'm looking at variation in revenues or variations in cost the 69 00:09:40,720 --> 00:09:48,200 risk the risks inherent in your fixed costs the risks inherent in your variable costs the risks 70 00:09:48,200 --> 00:09:56,600 inherent in your profit and all of that. We use this animal right here to do that more specifically 71 00:09:56,600 --> 00:10:05,720 we probably use the coefficient of variation. The coefficient of variation CV is the standard 72 00:10:05,720 --> 00:10:16,400 deviation divided by the average which takes away the scale the size of the numbers so that we can 73 00:10:16,400 --> 00:10:23,840 compare for example fixed cost might be very large compared to variable cost or vice versa. When you 74 00:10:23,840 --> 00:10:31,160 use the CV it corrects for those differences in size so you get a pure measure of the relative 75 00:10:31,160 --> 00:10:37,160 risk levels of the different lines on your accounting statement or on your managerial 76 00:10:37,160 --> 00:10:46,000 accounting sheets. That's all that is and it's very useful even for us it's useful too but our big 77 00:10:46,000 --> 00:10:57,880 800 pound gorilla is always beta. Now the beta I'm going to write this down I want to talk about 78 00:10:57,880 --> 00:11:03,560 this a little later and I'll show you where you could actually do this. The beta let's say of a 79 00:11:03,560 --> 00:11:15,120 stock is the Pearson correlation coefficient of that stock with the market portfolio times the 80 00:11:15,120 --> 00:11:20,880 standard deviation of the stock over the standard deviation of the market portfolio. That's how we 81 00:11:20,880 --> 00:11:26,880 get betas and you can calculate them they're not that hard to calculate. Now yours would probably 82 00:11:26,880 --> 00:11:33,920 be off a little bit or maybe a little more than a little bit because technically and I said this 83 00:11:33,920 --> 00:11:43,880 last time in Wednesday's lecture the beta you're supposed to use expected returns and expected 84 00:11:43,880 --> 00:11:50,120 standard deviations but mostly we're going we would be working with historical data so there 85 00:11:50,120 --> 00:11:57,600 would be a difference between what you see and what some big reporting service would show because 86 00:11:57,600 --> 00:12:03,920 it could do the crunching to get expected numbers instead of from the historical numbers. Anyway 87 00:12:03,920 --> 00:12:12,880 that one's there too. Another measure of risk and I kind of dismissed this one but it does have a 88 00:12:12,880 --> 00:12:26,960 useful part to it. The Sharpe ratio which is the return to your stock or portfolio minus the risk 89 00:12:26,960 --> 00:12:38,080 free rate over the standard deviation. In fact I've got a sheet that you'll be able to pull up later 90 00:12:38,080 --> 00:12:45,120 a risk and return sheet where it will do the Sharpe ratio it's just a one of the calculations 91 00:12:45,120 --> 00:12:55,080 that it does when you put in data. Now the Sharpe ratio as I said okay here's the big 92 00:12:55,080 --> 00:13:01,800 criticism of Sharpe. Sharpe uses a standard deviation as the metric of risk instead of 93 00:13:01,800 --> 00:13:10,200 beta as a metric of risk. I don't know it's just been around forever and it's almost always if 94 00:13:10,200 --> 00:13:14,680 you look at a mutual fund they'll report the Sharpe ratio it's easier to find the Sharpe ratio 95 00:13:14,680 --> 00:13:24,240 in the reporting than it is the beta sometimes. It's a number and it's kind of a it's a big thing 96 00:13:24,240 --> 00:13:32,480 here. Let me show you something here. Now there's something that's on the side here and I can turn 97 00:13:32,480 --> 00:13:54,840 let me turn off these lights so you can see a little better in here but R minus R sub F. The book, 98 00:13:54,840 --> 00:14:09,400 later it says it the way I say it but at first they call this the risk premium. The risk premium. 99 00:14:09,400 --> 00:14:33,760 Later, technically what we call this is the market premium over risk-free. 100 00:14:40,160 --> 00:14:50,600 You'll hear me call it the market premium. The market premium over the risk-free rate and you 101 00:14:50,600 --> 00:15:04,200 would do this for a stock like that. Here's what it's telling you. You can go risk-free anytime 102 00:15:04,200 --> 00:15:10,680 you want. You look like a very timid fearful investor. A man who would never take a chance 103 00:15:10,680 --> 00:15:19,000 on anything. When they say would you like to have corn flakes or grape nuts you say I don't go and 104 00:15:19,000 --> 00:15:27,720 get it over my head I'll have the corn flakes. You're the guy who drives at 25 miles an hour 105 00:15:27,720 --> 00:15:34,960 on the Autobahn as cars try to go around you and they take off your the sides of your car and their 106 00:15:34,960 --> 00:15:48,040 wins here. Okay you're the guy who did not want to go to college because you could go right out and 107 00:15:48,040 --> 00:16:00,320 get a job at $8 an hour. No risk of college for you but if you had gone to college you would have 108 00:16:00,320 --> 00:16:10,760 made $50 an hour. So there's a risk premium that you would realize by bearing risk instead of bearing 109 00:16:10,760 --> 00:16:27,160 no risk. So in other words this thing this animal right here and would be if I write it this way R 110 00:16:27,160 --> 00:16:41,400 sub M minus R sub F. This is the market premium. That's the market premium. So in other words if 111 00:16:41,400 --> 00:16:52,800 we expect the return to the market this year to be 16% and the risk-free rate is 4% then the market 112 00:16:52,800 --> 00:17:05,680 premium over risk-free is going to be 12%. This is your reward for bearing the risk of the market 113 00:17:05,680 --> 00:17:16,520 portfolio. This is your reward for bearing the risk of the market portfolio and that is hugely 114 00:17:16,520 --> 00:17:35,520 important to us because if you take beta of a stock times R sub M minus R sub F. Beta is what 115 00:17:35,520 --> 00:17:44,960 magnifies or demagnifies the market premium that you will realize. So in other words if I took a 116 00:17:44,960 --> 00:18:06,640 beta let's take a couple let's say beta 1 is 1.00 that would mean that you would have 1.00 times 117 00:18:06,640 --> 00:18:23,400 16% minus 4%. So you would earn exactly your your premium for the risk that you took at a 1.00 beta 118 00:18:23,400 --> 00:18:38,040 would be exactly the market return. If however let's say that you decided that you were going 119 00:18:38,040 --> 00:19:07,160 to take 1.5 beta then you would be have 1.50 times 16% minus 4% which would be 18%. That would be 120 00:19:07,160 --> 00:19:17,720 what you would earn because the beta has magnified the market premium. Suppose instead that you took 121 00:19:17,720 --> 00:19:45,520 a beta of 0.5 that would mean which would be 6%. You take half of the market risk you get half of 122 00:19:45,520 --> 00:19:56,120 the markets reward. Now one special one here suppose that you did not want to take any risk 123 00:19:56,120 --> 00:20:03,480 beta 4 I'm sorry I'm writing these all over the board here these tiny little boards they have here 124 00:20:03,480 --> 00:20:13,800 beta sub 4 is 0.00 in other words you want something that has no beta risk. Well in that 125 00:20:13,800 --> 00:20:32,160 case you would have 0.00 times 16% minus 4%. You would get no reward for bearing any of the 126 00:20:32,160 --> 00:20:37,720 market risk. Now that doesn't mean you won't get a reward that's where CAPM comes in but as far as 127 00:20:37,720 --> 00:20:47,200 market driven risk you get none. That's all the beta is. Beta is nothing but a magnifier or 128 00:20:47,200 --> 00:20:56,920 demagnifier on the market premium. Beta is nothing but a magnifier or a demagnifier on the market 129 00:20:56,920 --> 00:21:08,720 premium. See the market premium is 12%. Beta is going to either magnify it or demagnify it. 130 00:21:08,720 --> 00:21:22,320 That's all beta does. But this is driven by the markets conditions. So as the expected return to 131 00:21:22,320 --> 00:21:30,400 the market portfolio changes or as the risk-free rate changes then this magnification or 132 00:21:30,400 --> 00:21:58,960 demagnification is on a different number. Let me take this off the board here just put it together. 133 00:21:58,960 --> 00:22:14,080 We start with a premise here. No investment would give you less than the risk-free rate. Because 134 00:22:14,080 --> 00:22:25,560 suppose I'm going to give you an investment sir that is risky as hell but you can and you will 135 00:22:25,560 --> 00:22:35,760 earn just what you would get on a Treasury bill that has no risk. Well you'll say kiss my ass I'm 136 00:22:35,760 --> 00:22:45,560 not going to do that I'll just take the Treasury bill. Okay I can give you ten dollars to walk out 137 00:22:45,560 --> 00:22:52,200 that door on the first floor or I can give you ten dollars to jump off the fourth floor balcony 138 00:22:52,200 --> 00:23:06,760 outside there. Either way you get ten dollars which one are you going to take? No because he'll be 139 00:23:06,760 --> 00:23:12,880 sued by the squirrely lands on those fat ass squirrels out there. The damn beggars walk up to 140 00:23:12,880 --> 00:23:20,320 you and can I please have something for? Get away from me you fat ass squirrel. Anyway but what I'm 141 00:23:20,320 --> 00:23:28,360 trying to get to here is that there's not going to be in a reasonable world any investment that 142 00:23:28,360 --> 00:23:38,520 would pay you below the risk-free rate. And so we could say well what did that mean for the expected 143 00:23:38,520 --> 00:23:52,160 return to a stock? Well the first thing it would mean is that you would earn the risk-free rate 144 00:23:52,160 --> 00:23:59,560 you would earn it because no investment is going to give you less than that because you would just 145 00:23:59,560 --> 00:24:10,200 go over and buy Treasuries if that happened. And then in addition to that you will get the market 146 00:24:10,200 --> 00:24:22,280 premium times the magnifier the beta. That mother right there is called the capital asset pricing 147 00:24:22,280 --> 00:24:29,280 model the capital asset pricing model the CAPM. This is what I was telling you about at the 148 00:24:29,280 --> 00:24:38,200 beginning if you're going to get a tattoo you cannot get wrong with this one. Large font times 149 00:24:38,200 --> 00:24:50,760 new Roman maybe just for the tastefulness of it. There you go. That is this now a little bit of a 150 00:24:50,760 --> 00:24:56,760 historical background on this just to make sure you know where where we are. There are competing 151 00:24:56,760 --> 00:25:05,880 models. There's one called APT the arbitrage pricing model. It's basically this one but it 152 00:25:05,880 --> 00:25:12,960 says that there are different betas attached to an investment and you would have to add in and I'm 153 00:25:12,960 --> 00:25:18,920 going to just write this here. Like this one might be the traditional beta and then there might be 154 00:25:18,920 --> 00:25:32,280 another beta times market premium and there might be another beta times the market premium. There 155 00:25:32,280 --> 00:25:41,360 might be a whole series of them. That's APT arbitrage pricing model but you know what many 156 00:25:41,360 --> 00:25:48,640 many studies have been done and most of them find out that worrying about these other weird-ass 157 00:25:48,640 --> 00:25:57,720 betas they don't do any better predicting return than the classic CAPM does. They really don't. 158 00:25:57,720 --> 00:26:05,800 Now we're always looking for another a better way because CAPM isn't perfect obviously. The 159 00:26:05,800 --> 00:26:14,000 expected return you calculate and what actually happens you know they can deviate. I'm going to 160 00:26:14,000 --> 00:26:19,760 talk about that in a minute that it's a very cool place to look but realistically speaking 161 00:26:19,760 --> 00:26:32,680 this works and in fact interestingly enough well let me go into this. I'll go into this. Graphically 162 00:26:32,680 --> 00:26:49,480 if I were to use this as the y and the beta as the x so on the horizontal axis we have beta on 163 00:26:49,480 --> 00:27:08,160 the vertical axis we have the expected return. Well the first thing we would know let's say so 164 00:27:08,160 --> 00:27:24,880 if on this axis here's 1.00 for beta I'm doing 0.2 increments here then we would know that a 165 00:27:24,880 --> 00:27:38,480 beta of 1 will yield the expected return to the market portfolio. Well that's what a beta of 1 166 00:27:38,480 --> 00:27:51,400 means. That's why we call it beta of 1. We also know that a beta of 0 would get us the risk-free 167 00:27:51,400 --> 00:27:58,760 rate R sub F. If you have no if the it's a risk-free interest instrument then we expect it to pay the 168 00:27:58,760 --> 00:28:09,760 risk-free rate. Now if you remember from linear your linear algebra two points create a line. 169 00:28:09,760 --> 00:28:22,280 This is the cap M graphically beta plotted against expected return. We call this line the securities 170 00:28:22,280 --> 00:28:41,880 market line. And it's just a plot so I could say well what would be a beta of 0.6 that's right 171 00:28:41,880 --> 00:28:53,200 here should be there. Beta of 1.5 should be right here. It's just a visual representation of cap M. 172 00:28:53,200 --> 00:29:08,680 But it has some interesting uses. First things first and this is my traditional rant from hell. 173 00:29:08,680 --> 00:29:15,440 We even have a contest we did I don't know if they're still running it but you see all of these 174 00:29:15,440 --> 00:29:25,240 talking heads. Well this fund manager got the highest return this year. Boy that guy's a real 175 00:29:25,240 --> 00:29:32,320 excellent son of a bitch yes indeed. We give out awards we had their contests all over the country 176 00:29:32,320 --> 00:29:43,520 and we had one here. The team that gets the highest return wins. It's two-dimensional they 177 00:29:43,520 --> 00:29:51,240 completely ignore what risk was taken. Yeah I can be a hero I can get a damn return clear up here 178 00:29:51,240 --> 00:29:58,000 about where Jesus lives but you are going to take a massive risk to do that appropriateness of 179 00:29:58,000 --> 00:30:13,160 investment. You're sure you can be I a matter of fact this was 2-3 41 maybe about six years ago. 180 00:30:13,160 --> 00:30:24,640 I had teens make portfolios and I said okay choose wisely and get it done great get a good 181 00:30:24,640 --> 00:30:34,720 return on it and I told them what I would expect them to get based upon cap M. Report cap M report 182 00:30:34,720 --> 00:30:41,760 what the expected return is and then at the end of the semester report what your return is. Okay 183 00:30:41,760 --> 00:30:52,040 so in other words you got to hit cap M. Well this one group they came in about two weeks before the 184 00:30:52,040 --> 00:30:57,480 end of the semester and they'd been working their beta was all over the place they were adding 185 00:30:57,480 --> 00:31:03,200 things pulling things out and I couldn't even figure out where the hell it was the beta but 186 00:31:03,200 --> 00:31:11,320 their return was negative eight percent about no negative seven percent and they said so basically 187 00:31:11,320 --> 00:31:22,760 we're screwed and I said what do you do? Have any of you ever was old college football term have any 188 00:31:22,760 --> 00:31:30,840 of you ever heard of the Hail Mary in football? You're clear back near your own goal line and 189 00:31:30,840 --> 00:31:38,800 the Hail Mary is that pass clear down the field fourth and 15 and you've just Hail Mary to throw 190 00:31:38,800 --> 00:31:43,360 it clear down the field and hope one of your guys catches it down there. Said you can do a Hail Mary 191 00:31:43,360 --> 00:31:52,240 liquidate the portfolio and just throw it into the highest beta thing you can find because I 192 00:31:52,240 --> 00:31:59,400 mean theoretically you put a bait out there at least two weeks you're going to have a return 193 00:31:59,400 --> 00:32:07,160 up there maybe well I'll be darned if they did and they came out pretty well I mean of course that 194 00:32:07,160 --> 00:32:12,840 was also a portfolio that could have crashed and burned them so that they would have not passed my 195 00:32:12,840 --> 00:32:17,160 course and matter of fact they probably couldn't have gotten a job at ace trucking Scott gotten his 196 00:32:17,160 --> 00:32:25,440 scholarship at ace trucking school okay but yeah you can I mean all this is doing is telling you 197 00:32:25,440 --> 00:32:32,760 look what do you expect to return based upon the beta but that's the important thing is that there's 198 00:32:32,760 --> 00:32:41,480 no such thing as a an expected return or a return to a portfolio it is always attached to a risk 199 00:32:41,480 --> 00:32:59,840 variable somewhere in there but here's the interesting thing we actual analysis puts the 200 00:32:59,840 --> 00:33:08,760 portfolios the real portfolios all around it now we have some anomalous portfolios it's more like 201 00:33:08,760 --> 00:33:15,280 it's not the real world doesn't lie on a perfect line it's a lies on a scatterplot so the world 202 00:33:15,280 --> 00:33:21,040 doesn't really oh god this is a cap M we better get these returns right there now it'll be around 203 00:33:21,040 --> 00:33:30,120 that now that we do see a few anomalies and it's the stuff of research papers and all that like 204 00:33:30,120 --> 00:33:38,200 for example there are there's an anomaly called the January effect where there are certain stocks 205 00:33:38,200 --> 00:33:46,920 classes classes of stocks that seem to violate cap M there's another one called a small cap 206 00:33:46,920 --> 00:33:56,520 phenomenon where certain types of small capitalization stocks seem to seem to come in above the 207 00:33:56,520 --> 00:34:06,520 securities market line however there's a more enduring phenomenon and you might actually be 208 00:34:06,520 --> 00:34:20,320 part of that not know it see most day traders and amateur investors lose money I in real terms or 209 00:34:20,320 --> 00:34:26,840 in terms of opportunity cost of the time and capital they put into doing day trading they lose 210 00:34:26,840 --> 00:34:47,280 it but every now and then we see a trader we see someone who routinely gets a return above the 211 00:34:47,280 --> 00:34:57,080 securities market line of course we see plenty of traders who are below it you see right here this 212 00:34:57,080 --> 00:35:08,360 trader above he is earning an abnormal return and it's not just a one-off this it wasn't a 213 00:35:08,360 --> 00:35:18,400 one-trick pony this one keeps staying above it we have a name for this distance right here from 214 00:35:18,400 --> 00:35:28,400 where cap M says he should earn or she and where he or she does earn we call that Jensen's alpha 215 00:35:28,400 --> 00:35:40,000 Jensen's alpha as a matter of fact there's a famous and very good website called seeking 216 00:35:40,000 --> 00:35:47,000 alpha have any of you ever heard of it what you're doing is a play for those who know what alpha is 217 00:35:47,000 --> 00:35:54,920 Jensen's alpha so of course trading house they're going to get free accounts because all we need to 218 00:35:54,920 --> 00:36:03,720 do is find you mr. genius and then we watch what you invest in and then we front run you you know 219 00:36:03,720 --> 00:36:12,000 what front running is no in front of you you say I want to put in this trade for this stock and a 220 00:36:12,000 --> 00:36:17,720 split second before we execute your trade we execute ours for what you did that's front running 221 00:36:17,720 --> 00:36:33,280 it's illegal okay but yeah we're looking for the pause we're seeking alphas yeah I get yours and 222 00:36:33,280 --> 00:36:41,200 you're going to go okay I got to watch how I say this you see there used to be a system called 223 00:36:41,200 --> 00:36:50,160 SOES small order entry system so that small orders got in first before large orders it was 224 00:36:50,160 --> 00:36:56,800 just a NASDAQ thing okay and they've changed it it's got a different name now I don't remember 225 00:36:56,800 --> 00:37:04,360 what the name is now but that's still the way it is so I as an insider in order to take advantage 226 00:37:04,360 --> 00:37:13,080 of this I cannot put in a big block trade what I'll do is I'll have a hundred a thousand phony 227 00:37:13,080 --> 00:37:20,080 shadow accounts each one will be a small order entry system I just have those happen and then a 228 00:37:20,080 --> 00:37:27,000 split second later I execute your order matter of fact the algo is simply okay this is one of our 229 00:37:27,000 --> 00:37:34,720 alphas this is an alpha trade and so the alpha will will electronically put in a mass order 230 00:37:34,720 --> 00:37:39,920 through the that each one of them will be small but they'll get through the SOES system and then 231 00:37:39,920 --> 00:37:46,240 yours will come in towards the back door of the other ones they'll muscle you out of the way and 232 00:37:46,240 --> 00:37:52,280 get theirs in you think it doesn't happen happens all the time we're always looking for it it was 233 00:37:52,280 --> 00:37:59,240 like up in Chicagoland I took my suits up to the White Sox so they could learn about finance at 234 00:37:59,240 --> 00:38:07,200 the White Sox and what they were we so they maybe get jobs there's something like that and they were 235 00:38:07,200 --> 00:38:17,320 we were at we were hosted by the White Sox charitable organization they spend a lot of 236 00:38:17,320 --> 00:38:24,560 money every summer setting up and funding Little League teams through Chicagoland hundreds and 237 00:38:24,560 --> 00:38:31,640 hundreds of Little League teams now do you think that they do this out of the beneficence of their 238 00:38:31,640 --> 00:38:41,320 hearts no all it takes is finding one little snot-nosed kid nine years old who's got an arm 239 00:38:41,320 --> 00:38:49,880 that just won't quit or one that knows how to hustle bases faster than anyone else or someone 240 00:38:49,880 --> 00:38:59,040 who just happens to be just unbelievable with that bat three four of those out of five thousand ten 241 00:38:59,040 --> 00:39:07,160 thousand kids and you have won your investment it's the same thing it's the same idea you're 242 00:39:07,160 --> 00:39:13,000 a charitable person but you're always looking for that winner and then you can milk that winner you 243 00:39:13,000 --> 00:39:17,680 find that kid you go to his family we're going to take care of you now we'll make sure you have a 244 00:39:17,680 --> 00:39:21,760 good place to live you've got food on the table and we're going to make sure that kid gets his 245 00:39:21,760 --> 00:39:27,640 school school work done we'll have tutors we'll do the whole damn nine yards for that kid if you 246 00:39:27,640 --> 00:39:33,800 will sign us with an option for that kid down the road for it for us to get him into the 247 00:39:33,800 --> 00:39:41,240 farm league a little later these are the kinds of things that happen okay and in trading we are 248 00:39:41,240 --> 00:39:47,800 always seeking alphas so are you know you hear about well she's an alpha male now we're looking 249 00:39:47,800 --> 00:39:55,100 for a completely different kind we're looking for the nerd the geek that just happens to have the 250 00:39:55,100 --> 00:40:01,320 magic we don't know why they have it hell they might use magic mushrooms we don't care but at 251 00:40:01,320 --> 00:40:06,080 the same time we're always looking for those players the ones that just seem to have a magic 252 00:40:06,080 --> 00:40:14,480 I was a casino when it back many many many years ago there was once in a while you see some son of 253 00:40:14,480 --> 00:40:21,480 a bitch he could not lose and of course I was getting poorer and poorer the more I paid 20 254 00:40:21,480 --> 00:40:27,240 played on the 21 table or something like that but that son of a bitch he just kept winning and it's 255 00:40:27,240 --> 00:40:38,360 a magic but anyway okay so that's an alpha that's a positive but don't get me wrong this guy down 256 00:40:38,360 --> 00:40:44,720 here that's a negative alpha so we're always looking for the alpha and as long as you stay 257 00:40:44,720 --> 00:40:53,720 at least alpha zero or a little bit above alpha zero you are actually beating the market the term 258 00:40:53,720 --> 00:41:01,480 beating the market is misused oh he got higher than the market portfolio so I beat the market 259 00:41:01,480 --> 00:41:08,080 no he just went out here hi see this is the return to the market portfolio sure you can beat that by 260 00:41:08,080 --> 00:41:14,840 just taking a higher beta on your portfolio but actually beating the market portfolio really 261 00:41:14,840 --> 00:41:25,280 means at that level of beta of your portfolio what did you do did you get above cap M did you get a 262 00:41:25,280 --> 00:41:39,520 positive alpha that is beating the market one more thing about that if I see one of you getting a 263 00:41:39,520 --> 00:41:45,800 positive alpha I know it's genuine and I also know that you probably won't do it again if you do I 264 00:41:45,800 --> 00:41:53,440 want to be your friend for life but I mean an out positive alpha for one year or for a couple of 265 00:41:53,440 --> 00:42:02,600 months it usually vanishes it's the enduring positive alpha that is a mark of a truly good 266 00:42:02,600 --> 00:42:10,240 small-time investor when I see a large investor who's constantly getting a positive alpha I 267 00:42:10,240 --> 00:42:20,240 smell a rat I smell insider insider trading that's all there is to it because the reality is that 268 00:42:20,240 --> 00:42:27,880 having a positive alpha you either have to have a gift or you have to have some kind of insider 269 00:42:27,880 --> 00:42:33,560 information that's just the reality of it I'm not gonna bullshit you about that you're someone well 270 00:42:33,560 --> 00:42:39,360 I beat the market every year okay first of all that means is that you took a high beta portfolio 271 00:42:39,360 --> 00:42:47,440 no no no it was at that beta I got a positive alpha every year okay exactly how are you doing 272 00:42:47,440 --> 00:42:56,320 this because the market if I identify you sir as having a positive alpha year after year I'm going 273 00:42:56,320 --> 00:43:00,760 to start trading in front of you and I'll suck your profit away you think the price stock price 274 00:43:00,760 --> 00:43:05,080 is going to go up to ten dollars well I'll make sure I buy into and drive it up to ten before your 275 00:43:05,080 --> 00:43:12,480 order ever gets traded so you will lose that gift because everyone will figure out what you're doing 276 00:43:12,480 --> 00:43:19,440 and because you signal it when you do the buy order or the sell order you're signaling to the 277 00:43:19,440 --> 00:43:27,040 market here I am and then everyone's going to come in there and take your mojo now a couple of 278 00:43:27,040 --> 00:43:36,360 things here first of all the return to your portfolio I mean this is kind of like stupid 279 00:43:36,360 --> 00:43:47,360 pet trick stuff weight of poor of portfolio of stock one times the return to talk sock one plus 280 00:43:47,360 --> 00:43:56,800 the weight of sock two times the return to sock two plus the weight of sock and times the return 281 00:43:56,800 --> 00:44:06,480 to stock and okay it's nothing hard you can just put it the return to the portfolio is the sum from 282 00:44:06,480 --> 00:44:13,120 i equals one to n of the weights of the individual components times the return to the individual 283 00:44:13,120 --> 00:44:20,680 components just take the weight times the return add them up some product on excel and you're there 284 00:44:20,680 --> 00:44:41,160 that's your dinner yeah however well let's get that one down I saw some look look at hers but 285 00:44:41,160 --> 00:44:48,400 one of the things about that is that the betas are a little bit suspect that she had those are 286 00:44:48,400 --> 00:44:59,120 high beta stocks another a really great example was a former senator matter of fact I think her 287 00:44:59,120 --> 00:45:11,040 niece is running for a congressional seat here in Illinois somewhere but she was had was in the 288 00:45:11,040 --> 00:45:19,160 secret meetings when the before the coat before the covert pandemic was known to the outside world 289 00:45:19,160 --> 00:45:32,480 and she unquestionably traded on vaccine stocks more importantly her husband is the chairman and 290 00:45:32,480 --> 00:45:41,400 owner of the New York Stock Exchange he did too they are untouchable there's no question that they 291 00:45:41,400 --> 00:45:50,400 were using secret information to trade in to take a profit to make money off the off the pandemic 292 00:45:50,400 --> 00:46:00,880 there were others we've count probably five representatives and one senator clearly and of 293 00:46:00,880 --> 00:46:05,120 course they're going to say we don't control our portfolios we have it all done through a 294 00:46:05,120 --> 00:46:12,880 blind trust and a portfolio manager well they have something called a telephone and they probably 295 00:46:12,880 --> 00:46:19,920 called the portfolio manager said get that hell into mrna moderna get your the hell into Pfizer 296 00:46:19,920 --> 00:46:28,800 pfe get yourself into AstraZeneca and get the hell out of this this this and this that's all it 297 00:46:28,800 --> 00:46:35,400 takes and of course politics that's which is why I always thought I should run for pop for a 298 00:46:35,400 --> 00:46:43,600 political position I mean I've got hell I got the damn charm for it but aside from that yeah 299 00:46:50,480 --> 00:46:56,600 yeah and that's why you want to watch those sons of bitches as closely as you can there are reporting 300 00:46:56,600 --> 00:47:04,600 services of report on insider trading that's just the CEOs and the C-suite people doing buys and 301 00:47:04,600 --> 00:47:11,680 sells keeping an eye on those giant dogs like that hard as hell because they hide under privacy laws 302 00:47:11,680 --> 00:47:18,360 they use private trusts and you can't see it until their financial disclosures and so by then of 303 00:47:18,360 --> 00:47:23,840 course it's too late to know what they're doing we have some tricks in the book to watch 304 00:47:23,840 --> 00:47:34,400 well if you're obsessed with her I mean she's pretty old for a guy your age but you know I 305 00:47:34,400 --> 00:47:41,160 mean don't get it don't get into this obsession that it's one political party the Republicans 306 00:47:41,160 --> 00:47:46,960 were the ones who played that game with the kovat virus only one Democrat and he's a dumbass 307 00:47:46,960 --> 00:47:54,360 and but at the same time and it's not just politicians don't get me wrong a lot of the 308 00:47:54,360 --> 00:48:00,880 wealthiest people in the world I mean Elon Musk and his brother were insider trading there's no 309 00:48:00,880 --> 00:48:06,560 question about it they've been chased around and around by the SEC on their insider trading 310 00:48:06,560 --> 00:48:13,360 they'll never burn them now if you do it mr. cousins you will be caught and you will be made 311 00:48:13,360 --> 00:48:22,160 into some hard timers old lady with a full wedding ceremony for ten years us at the bottom of the 312 00:48:22,160 --> 00:48:29,600 level if we do anything wrong even if we fart sideways out of our butts we're nailed the big 313 00:48:29,600 --> 00:48:35,400 dogs are hardly ever once in a while they'll make an example of a whale but for the reality of it 314 00:48:35,400 --> 00:48:42,840 finra is for us little people and that's just reality of it and they've had a finra representative 315 00:48:42,840 --> 00:48:53,000 here and I cooked her on the law floor and so I'm not invited to have to go to those again but 316 00:48:53,000 --> 00:49:04,360 anyway let me get on to something else here let me get on to something else here on this oh by the 317 00:49:04,360 --> 00:49:13,440 way the beta of a portfolio is the same thing the beta of a portfolio is nothing but the sum from 318 00:49:13,440 --> 00:49:22,720 i equals 1 to n of the weight of each stock in the portfolio times the beta of that stock you just 319 00:49:22,720 --> 00:49:30,640 take the weights on the beta and add them up and that's an important one to know because that gives 320 00:49:30,640 --> 00:49:39,400 you what the overall beta of your portfolio is now let me go back here though and talk about a 321 00:49:39,400 --> 00:49:53,280 lonely little animal called the Pearson correlation coefficient you see a stock has two kinds of risk 322 00:49:53,280 --> 00:50:08,520 as I said there is the total risk is the diversifiable risk the risk that can be removed 323 00:50:08,520 --> 00:50:30,520 through portfolio diversification plus the non diversifiable risk well the non diversifiable 324 00:50:30,520 --> 00:50:38,280 risk is beta your job is to make that diversifiable risk go away and that is that risk 325 00:50:38,280 --> 00:50:47,080 pooling that I told you about on Wednesday the more you put in the more the kinks in each the 326 00:50:47,080 --> 00:51:00,120 standalone risk goes away so if you were to make your own portfolio let me show you over here 327 00:51:00,120 --> 00:51:17,920 number of stocks on the horizontal axis and the total risk of the portfolio here if you have one 328 00:51:17,920 --> 00:51:25,560 stock in a portfolio you eat the risk of that stock both the diversifiable and the non diversifiable 329 00:51:25,560 --> 00:51:32,520 I think I already said it you buy Microsoft on its own that beta represents only about 40% of what 330 00:51:32,520 --> 00:51:41,200 you're going to face as far as volatility goes buying single stock is insane you're not going to 331 00:51:41,200 --> 00:51:47,320 get rewarded for something that you don't have to do you're not going to get any reward at all only 332 00:51:47,320 --> 00:51:56,320 for the diverse fought non diverse fibers but as you put in more and more stocks into a portfolio 333 00:51:56,320 --> 00:52:06,800 the non diverse the diversifiable risk component goes away and you ask them tonically approach the 334 00:52:06,800 --> 00:52:17,040 non diversifiable risk how many does it take 95% of the diverse viable risk will be gone with about 335 00:52:17,040 --> 00:52:26,480 35 stocks that's a bad thing though because you have to manage a 35 stock portfolio that's 336 00:52:26,480 --> 00:52:35,880 expensive and it's time-consuming because you've got to be constantly balancing the portfolio or 337 00:52:35,880 --> 00:52:51,120 you could buy an ETF the spider the S&P 500 spider SPY 338 00:52:56,560 --> 00:53:04,720 that son of a bitch has 500 stocks and you buy one share of that and you have the portfolio 339 00:53:04,720 --> 00:53:15,040 diversification of the S&P 500 in fact it is so well diversified that we use it as a proxy for 340 00:53:15,040 --> 00:53:28,160 the market portfolio because it's got so many stocks in it but here's the thing suppose that 341 00:53:28,160 --> 00:53:36,520 you want to build a portfolio and you go buy 35 stocks that's what you need to do is find 342 00:53:36,520 --> 00:53:43,760 stocks that have low correlation against each other so that when one's going up the other's 343 00:53:43,760 --> 00:53:53,880 going down and they are canceling out each other's standalone risk so how do we do that how do we 344 00:53:53,880 --> 00:54:04,120 find those well there is a wonderful place called asset the portfolio visualizer I can type in 345 00:54:04,120 --> 00:54:11,560 stocks and see what their correlation coefficients are so let me do that right now let's try 346 00:54:11,560 --> 00:54:29,440 Walmart WMT put a space oh I don't know meta is meta METE I thought I think it'll tell me 347 00:54:29,440 --> 00:54:49,120 I'm wrong let's try General Motors Tesla Pfizer give me give me some guidance here what else 348 00:54:49,120 --> 00:55:10,720 Apple oh a APL Lockheed Martin what is MA is it MA yeah let's do these now you can leave these 349 00:55:10,720 --> 00:55:21,480 alone you can be a little fancier if you want now what you get is a correlation matrix now you may 350 00:55:21,480 --> 00:55:27,480 have did they show well I keep forgetting you probably aren't fully through stats this shows 351 00:55:27,480 --> 00:55:34,600 each one against its counterparts so for example Walmart against Walmart has a perfect correlation 352 00:55:34,600 --> 00:55:43,800 1.00 here's my rule and you can do others will say different things my rule rule is no more than 353 00:55:43,800 --> 00:55:51,640 point 3l no more so I look over here Walmart and meta they would be great in a portfolio together 354 00:55:51,640 --> 00:55:58,400 because they're canceling out a lot they they're very poorly correlated at point one two Walmart 355 00:55:58,400 --> 00:56:10,280 against GM is great against Tesla against Pfizer now here's one right on the edge Walmart against 356 00:56:10,280 --> 00:56:15,800 Apple their points 3l that's right about I mean I don't even need to do that because I've got so 357 00:56:15,800 --> 00:56:22,640 many already Walmart and against MasterCard Walmart is actually one that would be good in any 358 00:56:22,640 --> 00:56:29,160 portfolio that would be sore what we call one of our keys for our portfolio would be a Walmart 359 00:56:29,160 --> 00:56:35,120 because it seems to be correlated with almost nothing now let's look at meta now this is 360 00:56:35,120 --> 00:56:44,000 symmetric about the diagonal so we'll go to meta we'll look at meta against GM yeah that's too bad 361 00:56:44,000 --> 00:56:55,840 test it's against Tesla not bad oh look at meta against MasterCard point three six now sometimes 362 00:56:55,840 --> 00:57:02,560 it's obvious why they're highly correlated and other times it's like WTF what you know hot why 363 00:57:02,560 --> 00:57:08,360 but here it is they would not be good in a portfolio together because they're not doing 364 00:57:08,360 --> 00:57:15,800 as much as other stocks would do look at General Motors come over here aha well obviously against 365 00:57:15,800 --> 00:57:27,280 Tesla it's about point 3l Pfizer yeah now that one would be why is General Motors have a nasty 366 00:57:27,280 --> 00:57:33,680 correlation with Apple who knows but against Lockheed Martin a defense industry company low 367 00:57:33,680 --> 00:57:43,640 but General Motors against MasterCard I know why General Motors credit they are subject to exposure 368 00:57:43,640 --> 00:57:52,880 of risks in the same credit extending industry that one's okay I got it Tesla against Pfizer I 369 00:57:52,880 --> 00:58:02,240 mean there's so it's obvious point zero six yeah sure but against Apple what and against Lockheed 370 00:58:02,240 --> 00:58:10,960 Martin oh that's a nice nice one point zero one MasterCard point two four not bad okay I'm going 371 00:58:10,960 --> 00:58:19,480 down here to Pfizer Pfizer against Apple and decent now that one Pfizer against Lockheed Martin 372 00:58:19,480 --> 00:58:25,240 what Lockheed Martin builds defense stuff and people get injured and Pfizer's medical stuff 373 00:58:25,240 --> 00:58:32,000 they give to them I don't know this MasterCard not bad Apple against Lockheed Martin who look 374 00:58:32,000 --> 00:58:41,840 at that Apple against MasterCard the hell oh they both they have credit facilities Lockheed Martin 375 00:58:41,840 --> 00:58:50,400 against MasterCard I got nothing I got nothing on that nope but do you see but do you see how 376 00:58:50,400 --> 00:59:00,520 this correlation matrix if for one thing I see right here Walmart is a key component of a portfolio 377 00:59:00,520 --> 00:59:09,560 because it's insensitive against almost everything and other ones that aren't too bad Tesla it's got 378 00:59:09,560 --> 00:59:19,360 a couple that worries me but I don't know Meta it's it's pretty good too against a lot of stuff 379 00:59:19,360 --> 00:59:24,760 except MasterCard you can go down the list here and you can see and you can type in your own 380 00:59:24,760 --> 00:59:33,120 symbols and before you decide to jump into a stock look at how it's correlated against something you 381 00:59:33,120 --> 00:59:40,440 already have use this portfolio visualizer it's just a great free tool it's been around for a 382 00:59:40,440 --> 00:59:49,180 long long long time and even my former students who are out there in the equities world they'll 383 00:59:49,180 --> 00:59:55,000 go back to and look at it when they're thinking of throwing in an investment because the last 384 00:59:55,000 --> 01:00:02,560 thing you want to do is put in two investments that feed each other's volatility you want them 385 01:00:02,560 --> 01:00:11,000 to cancel out each other's volatility and so you can get close faster down to that not your 386 01:00:11,000 --> 01:00:16,120 portfolio has nothing but non diversifiable risk in it kind of thing and you're never going to get 387 01:00:16,120 --> 01:00:23,200 there all the way but I will tell you a couple of one one little trick here along the way and this 388 01:00:23,200 --> 01:00:29,640 is something that I usually reserve for my 242 class investments let me show you something here 389 01:00:29,640 --> 01:00:38,040 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 390 01:00:38,040 --> 01:00:49,240 hustle this you can do this on Google the word the term that I'm going to show you and you can see 391 01:00:49,240 --> 01:01:05,680 this over and over again if we were going to draw risk total rest in an deviation against expected 392 01:01:05,680 --> 01:01:14,320 return against return let's just do returns to different stocks and portfolios now this has been 393 01:01:14,320 --> 01:01:20,520 done so many times it's ridiculous and you'll see if you Google after I tell you the word let's take 394 01:01:20,520 --> 01:01:32,840 oh Microsoft its total risk and its return its risk as standard deviation or coefficient variation 395 01:01:32,840 --> 01:01:45,000 you could do take some other stocks with higher risk take some little portfolios and big portfolios 396 01:01:45,000 --> 01:01:57,080 high risk low risk now these scatter plots as I said they are the stuff of dissertations from long 397 01:01:57,080 --> 01:02:09,720 ago when we were still a little amazed at what we were seeing taking higher risk and the returns to 398 01:02:09,720 --> 01:02:20,880 different portfolios of stocks bonds stocks and bonds little portfolios big portfolios and over 399 01:02:20,880 --> 01:02:36,320 and over what happens is that we get scatter plots and now with computers they can do this in the 400 01:02:36,320 --> 01:02:50,000 blink of an eye we see something emerge that comes from the world of physics and chemistry is it also 401 01:02:50,000 --> 01:02:58,000 in the world of kinesiology it's in the world of engineering mechanical engineering electrical 402 01:02:58,000 --> 01:03:07,280 engineering it's a principle of the universe no matter how many points we plot there is a place 403 01:03:07,280 --> 01:03:20,520 where on the other side of it it's white space we never see anything up in here the term in 404 01:03:20,520 --> 01:03:33,280 mathematics for it and in engineering and physics is envelope it's a performance envelope we see it 405 01:03:33,280 --> 01:03:41,200 you decide that you're going to become a beefy muscle builder you know you start playing the 406 01:03:41,200 --> 01:03:48,160 rocky music every morning ba ba ba ba ba ba ba ba ba ba have you ever seen the original rocky movie 407 01:03:48,160 --> 01:03:54,400 I thought as a kid I wanted to do that every morning he got up and he put five eggs in a glass 408 01:03:54,400 --> 01:04:01,200 and he drank them well I thought I was going to do that now that was that first time I did that that 409 01:04:01,200 --> 01:04:08,080 was when I realized what the term debris field means I mean down it went and then up it came but 410 01:04:08,080 --> 01:04:19,360 anyway but no matter how hard you try there's a point of weight level you cannot cross no matter 411 01:04:19,360 --> 01:04:28,640 what you do there is you've hit your envelope no matter how much you tweak your car there is a 412 01:04:28,640 --> 01:04:40,120 speed that you cannot get above no matter where we go in the universe there is a size of a star 413 01:04:40,120 --> 01:04:49,120 that is the limit we do not see one larger than that limit no matter how much power you put into 414 01:04:49,120 --> 01:04:56,640 an engine the speed of light is the barrier you can't cross it that's why we have to do tricks 415 01:04:56,640 --> 01:05:02,640 we're working on these warp drives that can technically they don't break the speed of light 416 01:05:02,640 --> 01:05:09,760 they just kind of squeeze space in front and stretch it in back but you see this envelope 417 01:05:09,760 --> 01:05:28,440 right here we call it in finance the frontier of efficient investments the frontier of efficient 418 01:05:28,440 --> 01:05:38,400 investments it cannot be crossed as a matter of fact if you type in Google a frontier of 419 01:05:38,400 --> 01:05:46,040 efficient investments investments images you'll see pictures of this and odd weird variations 420 01:05:46,040 --> 01:05:51,480 but you'll see this over matter of fact I've made one myself and it was on Google for years before 421 01:05:51,480 --> 01:06:04,080 it was replaced by more recent pictures of it it's just that's where the end is now what would be on 422 01:06:04,080 --> 01:06:17,160 that frontier well you see what would be on it would be market portfolios all of the stocks and 423 01:06:17,160 --> 01:06:26,140 bonds in the world in different combinations but all of them those would be market portfolios it is 424 01:06:26,140 --> 01:06:41,680 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 425 01:06:41,680 --> 01:06:51,280 you like let's say this is Microsoft stock it has that risk level and it has that return 426 01:06:51,280 --> 01:07:05,400 we should be able to get that return with a perfect portfolio right there so in other words this is 427 01:07:05,400 --> 01:07:24,360 all diversifiable risk only this part is beta risk because I could buy Microsoft but there's 428 01:07:24,360 --> 01:07:31,840 also a portfolio that would get me the same return with less risk because I wouldn't have 429 01:07:31,840 --> 01:07:43,440 that diversifiable risk in it now what does this mean you can't for example now okay here's here's 430 01:07:43,440 --> 01:07:53,440 the one of the ways that you can get as close as possible you get it's called super portfolios what 431 01:07:53,440 --> 01:08:02,280 you would do is you would get three very well diversified portfolios and you would put them 432 01:08:02,280 --> 01:08:13,400 together and they would actually get you closer to the frontier I mean you're talking about in 433 01:08:13,400 --> 01:08:20,000 millimeters but it actually is a portfolio management strategy you don't just buy the 434 01:08:20,000 --> 01:08:28,920 spider you grab the spider and another highly diversified ETF and another highly diversified 435 01:08:28,920 --> 01:08:37,760 ETF you just put three of these together and they'll squeeze out a little more of that non-diverse 436 01:08:37,760 --> 01:08:46,400 that diversifiable risk but even if you just got the S&P 500 you're pretty darn close to the frontier 437 01:08:46,400 --> 01:08:54,440 you can't get there that it's a theoretical place it's the envelope it's that weight that you'll 438 01:08:54,440 --> 01:09:00,720 never achieve but you can get closer and closer the more you're willing to get horny is it's that 439 01:09:00,720 --> 01:09:06,720 speed you can get closer and closer to it with your car but you can never quite get to that dream 440 01:09:06,720 --> 01:09:17,920 speed in it this is all in explosives we can yield more and more thermal energy out of a bomb a given 441 01:09:17,920 --> 01:09:25,080 chemical bomb but where's a certain place where we can't get any more explosive power out of it 442 01:09:25,080 --> 01:09:33,040 it's just the way the universe works it sets limits on them and says get closer to me and that's 443 01:09:33,040 --> 01:09:41,760 what we do a lot of time the portfolio management is we just get a couple of really well diversified 444 01:09:41,760 --> 01:09:49,880 portfolios and we put the damn things together and the result of it is that we get the same we get 445 01:09:49,880 --> 01:09:58,760 it the same expected return but a little less of that standalone risk as it were one of the things 446 01:09:58,760 --> 01:10:08,360 we do and like I said I there are a couple other I'm reticent to use the word tricks there are other 447 01:10:08,360 --> 01:10:17,880 ways that you can inch up to the frontier one of them believe it or not is to mix t-bills in and 448 01:10:17,880 --> 01:10:25,640 if you take me for 341 if you're that lucky I'll even show you how you pull that stunt it's pretty 449 01:10:25,640 --> 01:10:37,520 cool but this is the this is the introduction to finance that if before this you might have been a 450 01:10:37,520 --> 01:10:47,160 day trader but here this is where we you're looking inside and now you're seeing the mechanics of the 451 01:10:47,160 --> 01:10:53,600 flaws of physics and how they relate to what we do here in our subject that's all I have for you 452 01:10:53,600 --> 01:10:56,120 today I thank you