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Capital Asset Pricing Model (CAPM) - Financial Markets by Yale University #16 - YouTube
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The capital asset pricing model.
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It's a model of the optimal portfolio.
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It asserts that all investors will hold the optimal portfolio.
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So anyway, I showed you last time a scatter diagram which had on the horizontal axis,
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the return on the stock market and on the vertical axis,
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the return on Apple Computer.
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And there was a scatter of points,
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one for each year,
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the return on the market and the return on Apple for that year.
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And I have fitted a line to that scatter points.
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The slope of the line is called beta.
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The idea here is that individuals should diversify.
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They should hold all the many different eggs in their basket.
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But diversification is difficult for individual investors.
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Partly because if you're a small investor,
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you'd have to buy fractional shares of each company and you know,
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the stockbrokers prefer that you do what's called round lots of 100 shares.
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So, you just can't do it,
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you're too small to diversify.
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So you need some company to help you diversify your portfolio.
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So, the idea has been going back many decades,
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that people need investment funds to manage
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their portfolio for them and the investment funds can diversify optimally for them.
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So before the 1940s,
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we had what were called investment trusts.
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Later they became a different form called the mutual fund.
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The first mutual fund is Massachusetts investment trust,
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MIT, not the institute,
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in the 1920s but they didn't really take off until after the 1940s.
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So a mutual fund or management company,
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invests in your behalf in assets and it's mutual in that,
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it doesn't skim off profits to a class of stockholders,
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it's divided up equally among all the people who invest in the mutual fund.
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But the mutual fund puts together assets,
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hopefully, in a diversified manner.
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So, I know the question
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of whether we're really talking about complete diversification or not.
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Often when we talk about the Capital Asset Pricing Model,
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or I should say usually,
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it is assumed that we're diversifying across all stocks.
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And maybe all stocks and all bonds.
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But in fact, if you wanted to be completely diversified,
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you'd want to include other assets like real estate or commodities like oil, as well.
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I put this up because I- I had to take
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a exam to get licensed as a stockbroker at one point in
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my career till I had a company and it turned out I had to
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be licensed so I took the exam to become a stockbroker.
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I never was a stock broker in my life.
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And the exam study materials is
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a series seven exam that some of you might end up taking if you go into finance.
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They talked about classifying
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all the different investments that someone might make in terms of risk.
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So, there is low risk, moderate risk,
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moderate risk, high risk and speculative.
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Now they have a range of mountain climbers climbing to the top.
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Now they didn't say what- I had to memorize this for the exam.
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Something didn't- bothered me about it though,
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they didn't say what you do with this picture of a pyramid.
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So, it sounds like looking at the picture,
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like we are supposed to be climbing up to the most speculative investments. I don't know.
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But what I thought is,
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there's nothing wrong with this diagram,
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but somehow it's misleading.
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What, what CAPM says,
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doesn't matter what your risk is,
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you want to hold all of these.
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It will average out to be the best for you.
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So speculative; art, gems,
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precious metals, options, commodities venture, capital.
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I want all of them. Okay. Do you want these too?
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Yes, I want all of them. It's very simple.
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It's not like going to a candy store,
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you probably just buy one piece of candy.
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You walk into the candy store and say,
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"Give me one of everything."
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That's what you should do.
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Now, if you look historically at different asset classes,
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you find historically they have paid different amounts out on average through time.
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Jeremy Siegel was an old friend of mine at the Wharton School,
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has just come out with the fifth edition of his book 'Stocks for the long run'.
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And he calculates the average return on the stock market in
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the United States from 1802 to 2012.
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That's 210 years of data.
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It's a lot of data. And he finds that correcting for inflation.
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The real inflation corrected return on average for those 200 years was 6.6 % a year.
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On the other hand, the U.S.,
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the geometric average real short term government return was only 2.7%.
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So that the equity premium- equity means stocks.
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The premium of stocks over short term saving vehicles on average for 200 years, was 3.9%.
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So then, he poses it as a puzzle at the beginning of his book.
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How can that be?
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That's- 200 years is a long time.
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I'm thinking, everyone this year first thought,
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should invest in the stock market.
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Why does anyone invest in short term governments?
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So this is called the equity premium puzzle.
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How can it be that one investment has done so much better
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overall for 200 years compared to another?
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And that's what we're going to try to understand with
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the capital asset pricing model here.
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It's not just for the U.S. but not as dramatically.
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Will Goetzmann said that to some extent,
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the U.S. equity premium is a problem of reflex,
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a selection bias problem.
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The United States is the most successful capitalist country in the world, you might argue.
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I mean, someone might try to argue otherwise,
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but if we're not we're pretty close to it.
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So, you're looking at the success of
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stock market investments in the United States is misleading.
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So you might say, "let's look at another country,
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how about Russia?" All right.
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Well, let's think, whatever happened in Russia for taking a long from 1802.
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You know, I kind of remember there was something called the Bolshevik revolution.
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So basically, it was wiped out.
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You didn't get anything.
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So, they're not uniformly a good example but at least in the U.S,
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it seems like now,
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we may be making a fallacy in assuming that this will is
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God's law that stocks outperform other investments but it seems like there have been.
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So, do you think that using historic data as a standard deviation or expected return
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is really helpful in understanding what's going to happen in the future?
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Alright.
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You're getting at a basic issue is what do we know about the future?
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And does the past have any indication of the future?
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Big question.
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So, let me give you an example;
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Utilities stocks, that's electric companies, gas companies.
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They, they've... every month they,
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they've keep the lights on.
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They've been doing this for a long time.
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So they're boring stocks and they'd hardly ever have gone bankrupt.
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So people think those are safe stocks with a low beta or low idiosyncratic variance,
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and maybe they don't pay the highest return.
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Now, and so that would be... that would be
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supported by data for the last 50 years that they've been boring investment.
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So it almost seems reasonable doesn't it?
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That they're going to continue-what's exciting about them? You know?
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But on the other hand,
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if you look at the history of- I'm just bringing up utilities,
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they weren't always boring.
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Particularly the 1920s, when the world was becoming
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electrified and electricity was new and these lights were exciting.
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You've switched- in fact that this is an old room,
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I think you can still see the gaslights.
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I don't see them, they remove them.
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This was obviously lit by gas when it was built, not by electricity.
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Once the- the electricity is so much brighter and
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impressive so people were excited about it.
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So in 1929, that sector that grew the most and crashed was the utilities sector.
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So, that means you can't necessarily trust
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past behavior of stock prices as an indicator of the future.
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I think that it's kind of halfway,
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you can sort of trust it if you know a reason to think otherwise, then you wouldn't.
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When you get to other things like Facebook or Google, or whatever,
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or alphabet, what do you think about their future return?
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Is that predicted by their past return?
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Now, who knows?
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It's changing, everything is changing too fast.
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