Welcome to Finance and Excel video number 106.
If you want to download this workbook for chapter 11,
click on the link below the video
and scroll all the way down to the Excel Finance Class
section.
Hey, we're in chapter 11.
We talked about just the last two videos, calculating
expected returns and standard deviation
for a stock in a portfolio.
Now, expected returns, we can even go look back over here.
We expected with our calculations
to earn this much on the portfolio back in example 1.
For the stock, we expected to earn a return of 4.5 and 3.4.
So what does expected mean?
Well, since this is all about estimating
for the unknown future, that's as best we can do.
Is it going to be exactly this or exactly this?
Highly unlikely.
So what happens?
We make these estimations, and then what happens?
It's a stock, right?
So some new information comes out,
as soon as new, unexpected information comes out,
there is no way we could have known about it, right?
So we didn't incorporate it into all of our estimates.
So our expected return is different
than our actual return.
Now, here's our PowerPoint, expected return
and actual returns.
Do they always equal each other?
Like never, right?
So if new, unexpected information comes out
about publicly traded stocks, prices can change,
and expected returns can be different than actual returns.
Let's look at an example in Excel.
I'm on the sheet example three.
New information September 30, 2004.
Merck announced recall of Vioxx.
Stock fell from 45 to 33 bucks in one day.
So this was September 30.
This was the day before.
This was the close the day before,
and here's what it ended on September 30.
So what's the change?
So the begin or the end amount divided by the
begin at the beginning of the day minus 1.
So new information can change a stock price
by a drop of 27% in a single day.
Yeah, that's an extreme example, but information,
new, unexpected information changes everything.
All right, new information and stock price that we just
saw that example there.
Unexpected new information, a surprise, in essence,
affects stock price up or down.
What happens if the stock price if the government announces
lower than expected economic growth numbers?
If you listen to the radio or watch the news at all, business
stuff, you know, you hear about this all the time,
some new government number comes out, and then, in this case,
you know most stocks would tend to go down, right?
So lower economic growth numbers,
stocks tend to go down.
What if Boeing-- what happens to Boeing stock
if they get an unexpected new contract for planes,
or they were going to sign a contract, and everyone expected
10 planes, and all of a sudden, now
when they sign it and announce it, it's 20?
The stock probably goes up.
How about unexpected announcement
that Ireland and Spain credit rating went down?
So this is-- I'm shooting this in November, almost
December 2010, right?
That's the latest international news, and as soon
as this comes out, that we already went through the Greece
government debt problem.
Now Ireland and Spain are in trouble.
It's just rippling through.
So what happened in the markets?
The prices went down.
People are scared.
If Ireland goes down, maybe Spain's next,
and now you start and get into two large economies.
And what's going to happen to the currency euro?
So this simple announcement just has ripple effects,
and it's unexpected, right?
People were cautiously optimistic
after Greece was sort of helped out a bit,
but this new information really caused a big splash.
What about unexpected announcement
that Boeing employee strike was not settled?
So unexpected, right?
They were on the verge of--
everyone expected this strike to be settled,
and then all of a sudden, it's announced no.
The talks have broken down.
So then what happens?
The stock probably shoots down.
All right, expected information.
Well, we were talking about unexpected,
but announcements that do not contain
new expected information should not affect stock price much,
right?
And the way they usually talk about this is new information
comes out, and they're like oh yeah,
that stock or the stock market didn't move much because it's
already-- the information is priced in to the stock
market or the particular stock.
They also say, oh, that's already discounted
into the stock price.
So what happens to stock prices if government
announces low economic growth numbers,
but everyone expected it?
Well, nothing, right?
That's why it's called expected return.
We built all of our expectations about what
we thought would happen.
What happens to Boeing stock if they
sign a new contract for planes, but it's
exactly what everyone expected?
Probably not much.
Now, let's go back to this slide.
Government Boeing, economic numbers, growth numbers,
affects a lot of stocks.
But this announcement about Boeing,
it affected just their stock.
So there's really two kinds of unexpected information.
And still further, notice that this new information,
if it's new and unexpected, it affects stock price,
but expected information doesn't really change it much.
So that means that the risk of the-- new information
means that really is the risk.
Anything that's different than our expectations
becomes the risk of the stock, unexpected new information
that the risk of holding the stock.
But as we just notice, there's two kinds of risk.
There is market risk.
Oh yeah, the market risk affects all the stocks,
announcements about GDP, interest rate, credit, country
credit rating changes.
That's either called market risk or systematic,
meaning this new announcement affects the whole system.
And then there's the Boeing risk, right?
Asset specific risk or unsystematic.
It means it doesn't affect the whole system.
So asset specific risk affects one, two, or a few stocks,
or for certain sector, right?
So Boeing example.
What about a liability lawsuit?
So all of a sudden, a new lawsuit
against a company and a product is announced.
That'd probably make the stock drop, right?
Or how about a new stock?
So this company announces a brand new stock, or a company
has a credit rating downgrade, so not a country,
but an individual company.
All of those are asset specific.
Now we want to talk about these two types of risk,
systematic and unsystematic.
I usually call them market and asset specific.
What happens to these if you hold lots of stock?
So if we go over here to slide 13 portfolio of stocks,
portfolio just means portfolio diversification
is the word they use is the investment
in several different asset classes or types of stocks.
And what this doesn't mean it diversification is not just
holding a lot of stocks.
Because what if you held 30 bank stocks?
Are you diversified?
So if an asset specific or a sector specific new information
comes out right, well, if it's about banks,
then it's going to affect all of your stocks.
So that's not really diversifying.
However, if you own 30 stocks that
span 30 different industries and sectors,
then you're diversified.
And what happens when you're diversified?
Well, you can just imagine, asset specific announcements
and new information, they're only
going to affect a few stocks.
So maybe a few stocks go down.
But at the same time, on any given day,
maybe a few other stocks go up in a different industry.
So the idea that you hold a diversified portfolio
with lots of different stocks across different industries
and sectors maybe will help us out in lowering our risks.
So risks and portfolios of stocks, holding portfolio
of different types of stocks lowers the asset specific risk.
And what happens is they tend to wash each other out.
But it's never going to reduce the systematic risk or market
risk.
When people hold diversified portfolios of stocks,
the true risk is the market risk.
Therefore market risk, systematic risk
is the only risk that is rewarded in terms
of the financial markets.
Now there's some famous studies, and here's
a table from our textbook.
All they did was they took different stocks.
They held one and two and four and six and all the way
up to 1,000, right?
And they measured the standard deviation or the risk,
the volatility of the stocks.
And sure enough, look at this.
When you hold one stock the volatility is 49.2,
starts to drop, 6, 8.
And again, the idea is as you get more stocks, when
one goes down, the other one stays neutral or goes up,
right?
So the asset specific or unsystematic risks
kind of wash out.
So as you get down to some number around 30,
right, it's down to 20 already.
And then as you get up more and more
and more and more for this particular study, you know,
it just approaches some number like 19.
And here's a chart of it, right straight from our textbook.
This is number of stocks in your portfolio.
This is the average annual standard deviation,
which is our measure of risk.
The more stocks are [TRILLING],, but it approaches
right about here, and somewhere it
gets pretty close to 20, about 30 stocks.
And so what that means is in the financial markets,
it's assumed that people hold portfolios of stocks.
And so therefore, the only risk that's going to be rewarded
is market risk or systematic risk or non-diversifiable risk,
because you can't diversify away from a new announcement
an unexpected announcement that's
going to affect the whole system or the whole market.
Now, the next logical step is how in the world
do you measure systematic risk?
Because if we could do that, then we
could come up with a measure to figure out
what the returns should be.
Beta, what's beta?
Oh beta.
Beta is a measure of market risk, systematic risk.
It just tells us how much systematic risk there
is in a particular stock or portfolio.
Now, in this textbook, they kind of just tell you, that's it.
Beta.
Beta of 1.
What they say is the beta of 1 implies
the asset has the same systematic risk
as the overall market.
So if you pick a stock with 1, and the market's going up
by a certain amount, then this particular stock
is going to be correlated with that.
It's going to go up.
Now, you can have a beta less than 1.
And this implies that the asset has less systematic risk
than overall market.
Above 1 implies more systematic risk.
Now, again, they don't tell you how to calculate this,
but I'm going to show you.
Here it is.
And by the way, this just says exactly 1.
That means your stock is average.
It's just like the market.
It's the average systematic risk.
They say below 1 or greater than 1.
It also can be negative, which means your stock
moves in completely opposite direction of the market.
Now here's our example.
I want to see how to do this over in Excel.
It requires that we do linear regression
and do the least squared method to calculate
the slope of a line.
What happens is you can in Excel do it
quite easily without doing least squared method, but you plot--
I'm going to do Whole Foods Market International, WFMI.
And I'm simply going to take all of the stock data
for this stock and plot it against some big index,
like the S&P. So here's S&P weekly returns for the lat--
oh, it should say last.
And here's another lat over here.
But this is the Whole Foods Market.
And so I plotted it.
Now, notice this is an x, y scatter,
which means there is an independent variable
and a dependent variable.
So we go out this much and out this much.
You can see there is some relationship.
So Whole Food Market tends to go--
when the market's going up, this one tends to go up.
And when we plot this and find the slope of this line,
that will tell us beta.
Now, for this particular example,
we're going to see that the beta of Whole Foods Market is 1.08.
Now I'm going to show you how to calculate it in the next video,
and we'll see how to do portfolio beta also.
So in this video, we just are learning about new information,
unexpected information.
It can be either systematic or unsystematic.
The systematic is the one that's rewarded in the market,
and we measure it with beta.
OK, in our next video, we'll see how
to calculate beta and do a couple
other calculations with beta.
All right, see you next video.