the capital asset pricing model it's a
model of the optimal portfolio it
asserts that all investors will hold the
optimal portfolio so anyway what what I
showed you that last time a scatter
diagram which had on the horizontal axis
the return on the stock market and on
the vertical axis the return on Apple
computer and it was a scatter of points
one for each year the return on the
market and the return on Apple for that
year and I had fitted a line through
that scatter of points the slope of the
line is called beta the idea here is
that individuals should diversify they
should hold all the many different eggs
in their basket but diversification is
difficult for individual investors
partly because if you're a small
investor you'd have to buy fractional
shares of each company and you know the
stock brokers prefer that you do what's
called round lots of a hundred shares so
you just can't do it you you're too
small to diversify so you need some
company to help you diversify your
portfolio so the idea has been going
back many decades that people need
investment funds to manage their
portfolio for them and the investment
funds can diversify optimally for them
so before the 1940s we had what were
called investment trusts later they
became in a different form called a
mutual fund the the first mutual fund is
Massachusetts investment trust MIT not
the Institute in the 1920s but it it
didn't they didn't really take off until
after the 1940s so a a mutual fund or
management company invest on in your
behalf in assets and it's mutual
in that it doesn't skim off profits to a
class of stockholders it's divided up
equally among all the
people who invest in the mutual fund but
a mutual fund puts together assets
hopefully in a diversified manner so I
now the question of whether we're really
talking about complete diversification
or not often when we talk about the
capital asset pricing model or I should
say usually it is assumed that we're
diversifying across all stocks and maybe
all stocks in all bonds but in fact if
you wanted to be completely diversified
you'd want to include other assets like
real estate or commodities like oil as
well I put this up because I had to take
a exam to get licensed as a stockbroker
at one point in my career if I had a
company and it turned out I had to be a
licensed so I took the exam to become a
stockbroker I never was a stockbroker in
my life but and the exam study materials
there's a series 7 exam that some of you
might end up taking if you go into
finance they talked about casts
classifying all the different
investments that someone might make in
terms of risk so there's low risk
moderate risk moderate risk high risk
and speculative now they have a new age
of mountain climbers climbing to the top
now they didn't say what I had to
memorize this for the exam but something
somebody didn't fathered me about it
though they didn't say what you do with
this picture of a pyramid so it sounds
like looking at the picture like we are
supposed to be climbing up to the most
speculative investments I don't know but
what I thought is there's nothing wrong
with this diagram but somehow it's
misleading what what cap M says doesn't
matter what your risk is you want to
hold all of these it could average out
to be the best for you so especially art
gems precious metals options of
commodities venture capital I want all
of them ok do you want these too
yes I want all of them it's very simple
it's not like going to a candy store you
probably just buy one piece of candy you
walk into the candy store and say give
me one of everything that's what you
should do now if you look historically
at different asset classes you find
historically they have paid different
amounts out on average through time
Jeremy Siegel who is my old friend of
mine at the Wharton School has just come
out with the fifth edition of his book
stocks for the long run and he
calculates the average return on the
stock market in the United States from
1802 to two hundred two thousand twelve
that's two hundred and ten years of data
it's a lot of data and he finds that
correcting for inflation the real
inflation corrected return on average
for those two hundred years was six
point six percent a year on on the other
hand the US the geometric average real
short-term government return was only
two point seven percent so that the
equity premium equity means stocks the
the premium of stocks over short term
saving vehicles on average for two
hundred years was three point nine
percent so then he poses it as a puzzle
in the beginning of his book how can
that be
that's two hundred years is a long time
I'm thinking everyone and this is your
first thought it should invest in the
stock market why does anyone invest in
short term government's so this is
called the equity premium puzzle how can
it be that one investment has done so
much better overall for two hundred
years compared to another and that's
what we're going to try to understand
with the capital asset pricing model
here it's not just for the
but not as dramatically well gets Minh
said that to some extent the US equity
premium is a problem of reflects a
selection bias problem the United States
is the most successful capitalist
country in the world you might argue if
someone might try to argue otherwise but
if we're not we're pretty close to it
so you're looking at the success of
stock market investments in the United
States is misleading so you might say
let's look at another kind of it how
about Russia all right well let's think
whatever happened in Russia if we're
taking along from 1802 you know I kind
of remember there was something called
the Bolshevik Revolution so basically it
was wiped out you didn't get anything so
they're not uniformly a good example but
at least in the u.s. it seems like you
know we may be making a fallacy and
assuming that this book is God's law
that stocks outperform other investments
but it seems like they have been right
you're getting at a basic issue is what
do we know about the future and does the
past have any indication of the future
big question so let me give you an
example
utilities stocks that's electric
companies gas companies they they they
every month they keep the lights on
they've been doing this for a long time
so they're boring stocks and they'd
hardly ever have gone bankrupt so people
think those are safe stocks with a low
beta or a low idiosyncratic variance and
maybe they don't pay the highest return
now and so that would be that would be
supported by data for the last
the years that they've been boring
investment I thought it almost seems
reasonable doesn't it that they're gonna
continue what's exciting about them you
know but on the other hand if you look
at the history of I'm just bringing up
utilities they weren't always boring
particularly the 1920s when electricity
the world was becoming electrified and
electricity was new and these lights
were exciting you switched in fact this
this is an old room I think you can
still see the gas lights I don't see
them they removed them this was
obviously lit by gas when it was built
not by electricity once the electric the
electricity is so much brighter and
impressive so people were excited about
it so in 1929 the sector that grew the
most when crashed was the utility sector
so that means you can't necessarily
trust past behavior of stock prices as
an indicator of the future I think that
it's kind of halfway you can sort of
trust it if you know other if you know a
reason to think otherwise then you you
wouldn't but when you get to other
things like Facebook or Google or
whatever or alphabet what do you think
about their future return is that
predicted by their past return and it's
hidden now where who knows right it's
it's it's changing everything's changing
too fast