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Risk and Diversification

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Transcript

Let's talk about risk and diversification. If you were to go and buy a product, and you weren't sure what the quality of that product is, you'd probably want to get a cheaper price than if you were buying something that you knew that what the quality was. So this risk in quality is called a discount. And we apply the same idea to when you're purchasing securities, you're going to pay or want to pay a little bit less for securities that have more risk associated with them. Let's take this with another example. Let's say you were selling insurance to people.

If you were selling insurance to people, you have to think about what is the risk of those customers? What is the likelihood that those people are going to make a claim on insurance? Well, if you make a contract insurance contract that is too onerous on the other party, and you say that well you have to fulfill this condition in this condition in this condition in this condition. You have to pay this high premium every month, then you might scare away honest, good counterparties good customers. And the only people that are left are the people who are going to claim for sure so they're willing to take your contract. You can try this with another example, such as banks that charge really high interest rates or credit card companies that have really high interest rates.

The people who actually take those at the end of the day, are unreliable borrowers and unreliable creditors, because those are the people who are willing to take those high interest rates because they know they're going to default or they're more likely to default and they have no other options. universities that claim patents on professors discoveries, those tend to attract lower quality professors. And that's why you'll see universities like MIT and Stanford. They don't claim very many patents on professors discoveries, those are usually quite open contracts that are suited towards the professor's advantage. Same with public health care, with free public health care, the citizens that are actually Under those health care plans, they tend to use a lot more health care services than they would if they weren't under free health care. And that's why free health care is often very expensive in a debates in politics.

So far, we've been just looking at individuals, so maybe one specific company at a time or stock. What happens if you group a bunch of stocks together? What risks are you facing then that's different than if you were just facing the risk of an individual stock? Well, let's take a look at this. One of the more famous models that they've used over the years is called the cap M or capital asset pricing model. And it works like this.

The return that you can expect to get is based off of three factors. First of all, the return from your risk free investment or the get backed by government bonds, treasury bills, etc. You have the return of the market, that you are going to be paid just for investing in the market, market risk. premium. And then of course, there's the risk of the individual stock, the individual security, we call this the idiosyncratic risk. And we call this the systematic risk.

The central idea is that if you have a lot of stocks together a lot of different securities, the individual effects of a single security doesn't really affect the portfolio that much, it has a negligible impact as you get a larger and larger group of securities together of different types and varieties from different industries. So one of the interesting benefits of that is, if that's no longer a factor, the only thing you're left with really affecting your return is your systematic risk. And that's made up of your market risk premium and this thing called beta. This thing called beta is essentially just the volatility of your security or portfolio in comparison to the market as a whole is just the way To measure how up and down the whole market is going as a whole. The beta is based on the idea that you have some kind of macro level changes, something that affects the whole market the whole portfolio.

Well, that sounds good. And that assumes that stocks move harmoniously, or that they move, the market moves all together at once. If they don't move all together at once, then that beta is a little bit less applicable. Well, it works well. In some countries, like historically in China, all the stocks tended to rise and fall harmoniously. But in the US in the later 20th century, the US stocks don't seem to rise and fall so much altogether.

Well, let's go back to the first example, when they do rise harmoniously. Why might this be? Well, let's think about this. This is where it gets interesting. If you're in a corrupt country, CEOs can steal profits. And they can have very suspicious accounting rules to make it look like they're having a very consistent trend upwards, alongside everyone else in the market.

But as accounting rules get more strict and better, we've noticed that stocks tend to move less harmoniously. During the year before a company issues, new shares, company profits tend to suddenly increase. Perhaps poorly governed companies are just following what other companies are doing. Maybe a dumb CEO is just following a smarter CEO of another company. Whereas if you're in a company that has a really smart CEO, perhaps they're doing their own thing, and so the company's completely acting indifferent to the rest of the market. In companies like Egypt, historically, it's been hard to get individual company information.

So the only thing that's left is macro trends. And that could mean that perhaps Since companies are only based on macro trends, the pricing that might not be too effective of the individual companies. In some countries, shorting or buying on margin is illegal, and that's gonna affect the price. And when foreigners with diverse information enter a market, we noticed that the market behaves less harmoniously as well. We normally think of bubbles just being in the financial market. But really, it just is referring to people acting all together because they don't really understand the factors involved.

And they all acting in the same way. There's a bunch of examples of similar things, the bubbles outside of the financial markets. In the dark ages, we had these things called witch burnings, where people in Medieval Ages would accuse each other of being witches. And they would have these ridiculous trials where people would be accused of being a witch, and if they were condemned, then they would be burned alive. And you didn't want to be accused. used to being a witch.

So one of the things you would do is you would accuse someone else of being a witch. And then you would hope that that way they wouldn't accuse you. In the Chinese Cultural Revolution, there was a period where everyone was destroying cultural items, because they didn't want to be accused of being a rightist. So what they did is they accuse other people of being a rightist and kept destroying cultural property. In Hitler's reign in Nazi Germany, there was gay bashing racism, prosecuting Jews, and one of the reasons that this kept happening and people went along with it is people didn't want to be accused themselves. So in order to avoid being accused, sometimes it was more convincing to accuse other people.

In the art community, you'll find artwork that's worth a ridiculous sum of money. And one of the reasons is that even if you don't understand the art, you don't want to be accused of being an idiot or not appreciating art. So you'll go along with it. And you'll say that this must be a beautiful piece of art because everyone else says it's a beautiful piece of art. Universities, sometimes you'll see these articles with complicated jargon words from a variety of subjects that mean nothing. And it's essentially pseudoscience.

It's not actually saying anything. It's just a large collection of words that is written in a very complicated manner. And one of the reasons is because professors sometimes don't want to be accused of being an idiot. So they'll read these long and complicated jargon. And since they don't understand it, either, they'll say, Well, this is this is a very, very in depth. This is a very deep, complicated, insightful work.

And they don't understand any more than the author understood, but they're able to get away with this because no one wants to be accused of being an idiot. There was a an unsophisticated tribe that saw planes that were flying overhead. And since they were very, very technologically evolved, they didn't understand what these planes were because they'd never seen them before. So they thought they were some kind of gods. And they started building these tribes of airplanes and worshipping them. Do economists and financial professors really understand what's going on or have any insightful ideas when it comes to efficient markets?

You'll see this term efficiency talked all over the place and universities but do they really know what efficient markets are? Or are they all just patting the back of one another? If a CEO likes a product, then management will find ways to show that the product or project has a profitable net present value it looks like a good opportunity. On the other hand, if a CEO dislikes the project, management will put together a presentation to show that the project has a negative net present value or doesn't look like it's a profitable opportunity. So one of the best practices to avoid all of these situations of jumping on the bandwagon is to use statistics to your advantage to eliminate any kind of bias. One example of doing this is a Monte Carlo simulation.

And this allows you to use statistics to give you a range of possible outcomes for each of your assumptions. And you can have a lot of assumptions. Now the Monte Carlo simulation isn't perfect it. There's still some limits and how practical that is. But there's a bunch of models you can use. Herbert Simon points out that we don't know what most economic distributions are.

So we satisfy so we just make some assumptions instead of spending the time to figure out what the actual value net present value are complicated calculations are needed to figure it out. JOHN Maynard Keynes points out that often we see CEO, his guts, just driving capital expenditures whatever the CEO thinks that's where money gets spent, and enterprise decisions. They only pretend to be driven by reason. But really, they've made a decision and then they figure out the reason after they made the decision. If this is the case, then capital budgeting analysis is kind of irrelevant. You're throwing in unknowable assumptions with unpredictable variables.

And the CEO is just making decisions based on hunches. So the investors confidence is really based on the CEO which may or may not actually have any reason behind their decisions. It might just be their gut. So rather than doing capital expenditures, calculations, sometimes CEOs just copy each other and one company copies what the other company does. And this can lead to harmonious trends in the market. It's similar to in modern art, where the price of art is just skyrocketing up for a single type of abstract art.

That doesn't actually mean anything to some people. But no one wants to look like an idiot. So they assume that the price of that art is expensive. Or when you go to the movies and you see some movies, rack up millions or even billions of dollars in box office sales. One of the reasons is because it's already been successful, there's already been a bunch of sales people don't even need to know anything more than other people have gotten to see the movie. So they're gonna see it as well.

It's just jumping on the bandwagon. And same with YouTube video views. If you see a video has many, many millions of views. You kind of want to see why it has many millions of views, and the video just gets even more. There's actually some interesting websites where you can purchase YouTube video views or Facebook likes or SoundCloud likes. It's kind of interesting.

It's actually relatively cheap. And although YouTube doesn't like it, it's used a surprisingly lot in the industry. Especially with music videos. Milton Friedman points out that CEOs, they're not stupid or they wouldn't be CEOs. So there must be some kind of value behind the intuition that a CEO has. He gives an analogy of, let's say you have someone who's a pool shark, they play pool really, really well.

And they don't need to know the physics behind how pool works and one ball and the angle links to one another. They don't need to know that they can still play pool without knowing. So CEOs invest in net present value or profitable projects without needing to know what the forces are behind them. So you can see that based on risk There's a bunch of factors that you can take into account. On one hand, you can be refusing to pay anything more. If you think something is risky and you'll demand a discount, you can group a bunch of different securities together and try to diversify out some of the idiosyncratic or individual security risk, however, then you're still susceptible to the market risk, and the market actually itself might have a little bit of risk depending on how harmonious Is it is it all moving together?

Or is it moving separately individually. If the market is extremely efficient, and everyone is acting on their own accord and not simply copying each other, then you don't have to worry so much. But if the market is moving harmoniously as it does in some countries, then you have to consider that as well.

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