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Efficient Portfolio Frontier - Financial Markets by Yale University #21 - YouTube
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So, what I want to do now is calculate the efficient portfolio of
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frontier which expresses the standard deviation of
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the portfolio in terms of r the expected return on the portfolio instead of X-1.
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So here is an example of the efficient portfolio frontier,
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I calculated for two investments,
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U.S. stocks and U.S. bonds using their historical expected returns,
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standard deviations, and covariances, variances and covariances.
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So what we have on this axis is the standard deviation of
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return and we have on this axis the expected annual return.
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So, and these are the possibilities we calculate with a formula.
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Let's consider a couple of special cases I have shown here.
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I can put all my assets in the stocks and then I would get an expected return
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equal to the return on stocks or I can invest
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entirely in bonds and I would be at this point here on the diagram.
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Bonds, these are long term bonds,
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they're risky because they're long term.
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Here, Professor Shiller mentions bonds are risky because they're a long term.
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I wouldn't fixate too much on the use of the term bonds here.
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We're analyzing the efficient portfolio frontier with any two risky assets.
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In this case he chose the example of stocks and
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bonds to emphasize that there are two separate types of assets.
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You could easily replace the word stocks and bonds
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with Microsoft stock and Tesla stock and the argument still works.
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Have historically,
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had a lower standard deviation of annual return but also a lower expected return.
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So I could achieve that by putting all of my money in
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bonds and I can achieve this by putting all of my money in stocks.
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What if I put half my money in stocks and half in bonds that puts me right here.
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So what we see is that there's an infinite number of possibilities.
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Oh, by the way, I could go more than 100% stocks if you like,
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I can go out here.
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So that looks like it's something like 120% in stocks and -20% in bonds.
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So to do that I'd have to short the bond market and buy the stock market.
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I can do that, I can do anything.
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It's just those two formulas that I just showed or the single formula for this curve.
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So what do you like?
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If you are investing your money and I showed you this, what would you pick?
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If Suppose you picked here then another adviser would come up and say, "you idiot,
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you could have picked up here and then you would have gotten more return".
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And note, no difference in risk,
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shorting the stock market is risky.
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If it has a negative expected return you don't want to do that.
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So what that means is that the hope curve here,
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below the minimum variance point is dominated,
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it's called the dominated.
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You don't ever want to be there.
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Well, what David Swensen says,
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"you know who is there before he arrived?
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Yale University was there."
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They had some fuddy duddy investment advisors who would say,
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"you know we've advised endowments of portfolios over the years and we find that for
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institutions like the Yale University they would do well to
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put their money in sound safe government bonds."
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And so, actually it wasn't David Swensen who first pointed out the foolishness of it.
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It was starting to come in with the whole capital asset pricing model.
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I think there was a Ford Foundation study of university endowments in
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the 60s that pointed out that
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universities are just stupidly putting their money in bonds.
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It used to be considered just smart,
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you know it was almost like religion,
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you had to do things the right way.
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In Europe, a lot of...
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a lot of foundations have put
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all their money in bonds because that was supposed to be safe.
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And then in Germany, in the 1920s,
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there was a hyperinflation in 1923.
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Every foundation in Germany was completely wiped out by the hyperinflation,
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they should have thought of this.
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It wasn't safe and they were
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undiversified and they were doing the under-performing under diversified asset.
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So, but it still takes a while you know you have
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university corporations or boards tend to be filled with various old fashioned educators.
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They can't imagine putting money in the stock market but David Swensen change that.
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So you don't ever want to be down here
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but you want to pick some point up here depending on
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your risk and it's a matter of taste where along this frontier you choose to go.
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So, here now I have the same curve that I showed you before for
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stocks and bonds and now let's add a third asset called oil.
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Okay?
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I did this with actual variances and covariances when I did this diagram.
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Forget this diagonal line for the moment,
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now I have three assets: stock, bonds, and oil.
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And so what is the minimum varian- minimum standard deviation
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I can get for any given expected return?
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And you can see there it gets more complicated now.
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The minimum variance portfolio...
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the minimum standard deviation portfolio would be 9% oil,
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27% stocks and 64% bonds.
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Up here, this is 21% oil, 79% stocks,
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0% bonds and here is 28% oil,
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115% stocks, -44% bonds.
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All those things are possible and so,
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now you might say I should take the minimum standard deviation, shouldn't I?
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Or is that right?
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Well, not generally, right,
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because you're sacrificing some return for that.
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You have to pick a point that reflects your tastes.
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So, now that we've added oil,
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you should not own a portfolio with just stocks and bonds in it,
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it's because the new portfolio frontier dominates.
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In other words, you can get the same return with a lower standard deviation.
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So putting our oil as a risky asset as you know recently.
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I've did this chart some years ago,
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so this is not updated but what we're seeing lately confirms oil is risky.
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It has... it was up to $150 a barrel or
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over that in 2008 and now it's under $30 a barrel,
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it's jumping around wildly.
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So you might say, "I'm going to stay away from oil."
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The answer is, "no you shouldn't,
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you should have if you want everything in your portfolio."
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But maybe you want something like this point.
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So you're only 21% exposed to oil,
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79 % stock, that sounds like a reasonable point.
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There are various possibilities here but the point
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is you don't want to... you don't want to just invest in stocks and bonds.
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Once you add oil there's more... there's
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more opportunity to achieve expected return without risk.
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Today's economy, there's so much uncertainty and
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many potential investors I think are fear- fearful of getting involved in the market.
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Is there a message that you think you would share with potential investors
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about what's going on today with fluctuating markets
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and how to kind of continue to stimulate our economy.
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Well it's going to be a mixed message.
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There is something inherently unsatisfying about investing in
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the stock market because you are putting yourself on
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the line for risks in so many different ways.
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And you can't possibly assess them all.
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Risks of financial crisis, risks of,
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I would say psychologically induced panics and
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so many people around the world have
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concluded-- I'm just going to stay out of stocks for example,
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because it's just a quagmire.
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I know that...
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I know that I can't figure out these investments
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and people are trying to sell me on this. I don't trust them.
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So that creates an atmosphere that inhibits
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business and business is ultimately the source of our prosperity.
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So I think, you know,
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the free market system that we have just kind of looks bad to a lot of people
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and you see people being taken advantage of sometimes and you think ,
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"there should be a pure system that
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let a lot of people towards various forms of socialism."
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But on the other hand,
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it just seems like all the fun stuff is happening in capitalist countries,
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I don't know if it's a capitalist but countries that have markets and prices.
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Let people do things for themselves on their own initiative and suffer the consequences.
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So, the world has come in this direction.
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You can't really escape
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the fundamental problem that business involves intuitive judgment,
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risk taking, you'll never know all of the risks,
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you know, that you have to be at some point,
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just think, "hey, I'm just going to try it."
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And you might get a bad outcome but I think...
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I think what we've learn about human society is that as funny as this system looks,
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it's a good system.
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