I want today to talk about some really

basic concepts about portfolios.

A portfolio is a collection of
investments.
And I want to talk about risk and return.
And eventually get into the, the core
theory
which is the capital asset pricing model
in finance.
First concept I wanted to talk about, is
leverage.
Well and also let me add the equity
premium.
These are the two main concepts.
Maybe I'll do equity premium first.
Here's the conundrum that people were
presented with, and I'll, I'll keep,
I'll stay in the VOC story but it's much
more general than that.
VOC, after a few years out, people thought
you know, this this company is amazing.
It's just growing so fast.
It's making so much money.
It might have a really high return like
unbelievably high.
Like 20% a year or even more but look,
lets
say, 20% a year and that's what generated
the excitement.
If it, if some people have wondered how
can it be?
Maybe, it's earned 20%.
But how can it, consistently, do that?
so, let me put puzzle.
We've gone through 400 years of history
since the VOC was established.
And since then, it seems to be remaining
true that companies' shares
do extremely well [LAUGH] and that's a
puzzle.
I, because you know, if, if you can make
a, a higher return on some investment.
Wouldn't you think that enough people
would flock into the investment so that
it no longer You know, there's too many
people trying
to do this, so it's no longer performing
so well.
But, in fact,
It seems like the, the
average return on stocks has been very
high.
This is a theme in Jeremy Segal's
book Stocks for the Long Run, which I have
on the on the reading list.
Segal has data doesn't go back to 1602,
but it goes back to the 19th
century, and he says that the geometric
average
return average annual return On the United

States stock market, from

1871 to 2006 was
6.8% a year corrected for inflation.
That's
6.8% a year after inflation.
So if you add a 3 or 4% inflation
rate that's 10% a year That, let's compare
that, with,
short-term governments which are the
safest thing in the United States.
The average rate of return on them was
only 2.8%
a year, okay, so the difference is 4% a
year.
So, for, well for a 100 years
in the United States, stocks performed
extremely well.
moreover, he points out that there was no
30-year period since
1831 to 1861 when bond when
Stocks under-performed either short-term
or
long-term bonds.
So the stocks have been good investments.
What do we make of that?
Don't people learn?
Think, if people learn, they would all
want to do the good thing.
Why does anyone invest in something else?
That was, that was the That was the puzzle
here.
It's not just a United States phenomenon.
The London Business School professors,
Dimson, Marsh and
Staunton wrote a book called The Triumph
of
the Optimists, that is optimists [LAUGH]
about the
stock market and they looked at the equity
premium.
In many different countries of around the
world.
And they found that all of the countries,
and that this is looking
over much of the 20th century, all of the
countries had an equity
premium, that the stocks did better than
the bonds of that country.
The lowest of the countries they studied
was Belgium, which had an equity premium
of only 3%, and the highest was Sweden,
which had an equity premium of 6%.
So, that's an interesting question.
How can it be that some asset, namely
stocks, outperform all other assets?
Okay.
So then that comes up then through what is
the standard answer?
Why is it?
The standard answer is 'risk'.

Stocks are riskier, the price jumps up and

down from day to day So you have
you have a the the extra return is a risk
premium.
And so that is what I want to pursue today
in this lecture.
Does that explain the equity premium And
how
should we think about the the equity
premium.
So what
I'm going to do is feature the the
theory that was originally invented by
Harry Markowitz
When he was a graduate student at the
University of Chicago.
And as a, or maybe it was shortly after he
was a student.
In 1952, he published a classic article in
the Journal of Finance.
That really changed the way we think about
risk.
In finance changed it forever.
It gets back at this core idea you know
people
looking at going back to the days of the
VLC.
People had the idea you know I think
stocks are the best investment.
OK I'm writing that down and I'm putting
it in quotation marks because its
not a term that I would use.
What is the best investment?
Well they say that look the VLC is just
returning tremendous amounts.
it, any smart person would just put as
much as he can into that investment.
Something seems wrong about that.
I mean, it can't be true that
so what Markowitz, I, I went back and read
his Journal of Finance article in 52.
It's kind of remarkable to me that what
he was talking about wasn't known yet in
1952.
He, he was getting at this core idea of
what's the best investment.
And how do you judge what's the best
investment?
And, judging from his article,
to me it sounded so basic and simple, of
course I've studied finance, but it seemed
odd to me that everyone didn't know that
in 1952.
so, let me,
question is.
Well, I, I've kind of paraphrased what
Marowitz said.
Let's imagine that you got a job as a
porfolio manager, okay?
And you're kind of mathematically

inclined.
And you know numbers and statistics.
And you know how to compute standard
deviations and variances.
Things like that.
So, what is the first thing you do?
You're a numbers person, okay, you're a
math person, but imagine
you've been in trusted with managing a
portfolio for some investor,
and the investor gives you a horizon, you
know let's say you're managing
it for one year, okay, and you're thinking
alright what should I do.
Well I, I want to collect data on every
possible investment I could make.
Not just stocks and bonds.
But real estate, and commodities,
whatever, okay?
And I can for each of these, I can
compute what the average return was on
those investments, okay?
And I
can compute the variance.
And I can compute the co-variance and the
correlation, right?
So Markowitz, do, do you see, so I've got
all the data.
Now, I could say, I don't believe these
data
are relevant to the future, because I'm
smarter, right.
I, I can predict that some company's
going to do better than it did in
the past or some asset class will do
better than it did in the past.
But let's, let's step back.
Let's do it basic.
Let's just think, like a Mathematician
here, alright.
Let's just take, as given, all the
historical average returns and variances
and co-variances.
Well Markowitz says, what's the best
portfolio, given that, okay?
I can compute all these numbers, what's
the best assembly of all these things.
And you know, he realized that nobody had
ever thought that.
Isn't that a well-defined problem?
I give you all the variants, I give you
all the co-variants, I give you
average returns and I say, let's just
assume
that this is going to continue like this.
What should I do, as an investor?
And, it's funny Markowitz said, he was
reminiscing, he won the Nobel Prize later,
and
deservedly I think.

This was a breakthrough idea.

But he said as a graduate student, he was
chatting with someone in the hallway and
thinking about this.
He said, it suddenly hit me as an
epiphany.
If I have the statistics, I ought to be
able to compute the optimal portfolio.
It's, it's, it's mathematical, right?
It's just one thing.
I mean, what is the optimal portfolio?
It took them like two or three
days to figure the whole thing out.
And, I, you know, it's almost like I
could, haven't I set up in your mind?
Do you see the problem?
You cold figure this out too, [LAUGH] you
put you ingenuity on
to it, the funny thing is, nobody thought
about it before Markowitz.
So let's think about that, you see the
concept I have, you all the variances,
this isn't a judgement thing, you know all
the co-variants that, what should I do?
Well the first thing I want to talk about
Is the very simple case of pure leverage.
Let's go back to 1602, okay, and there's
only one stock, and that's VOC, okay.
And, there has to be something else,
otherwise
there's nothing, the other thing I'm
going to say is.
There's an interest rate, risk-less
interest rate.
So I can invest in, let's say
Dutch government bonds which are
completely safe.
Of course you might say they're not
completely safe, but they're much safer
than V.O.C., V.O.C. was wild, the price
was going all over the place.
So, let's as an approximation say There's
an interest rate.
You can borrow and lend at the interest
rate.
And we'll call the riskless rate R sub F.
Okay.
And let's say that's 5% a year, okay.
We're investing for one year.
So I can invest at the interest rate.
And this is a boring investment.
It's just getting interest.
It's 5%.
But I can, I can also borrow at the
interest rate.
There's a market rate and
I can, I can borrow at 5%.
You know, in practice, I would probably
have to pay a little bit more
as a borrower than I could get as an

investor, but let's assume that away.

This is just an interest rate, and anybody
who
wants to can borrow and lend at the
interest rate.
I'll make it 5% just for a round number.
Okay.
And let's say VOC, the Dutch East India
Company,
has had a historic average return of 20%.
This is a spectacular investment, all
right?
But let's say it's, so that's its mean,
this mu, the mean of the investment.
But let's say, it's really risky, so the
standard deviation is 40%.
Alright?
So what can I do?
Suppose I have only, this is, let's do the
simple problem first, okay.
I have only one asset, VOC, and I have
riskless death.
So one thing I can do is, I'm going to
draw a chart here showing
[SOUND]
okay.
okay, I'm going to to sigma on this axis
and r on this axis.
So sigma is the standard deviation.
Of my portfolio.
Okay, and r is the expected return on the
portfolio.
Okay?
Now I, I, and I can, all I'm going to do
is choose mixtures.
Of the stock and the risk-less rate.
So a couple of points I can, I'm going to
plot what the available options are.
I, I can, I can see right here that I can
invest
at 5%, right, the risk-less rate, and then
I'll have no risk.
So do you see this?
This is r sub F.
This is 0.
Okay?
And these are positive numbers.
See what I've plotted here?
This is the most boring investment.
Because there's no risk at all, and I'm
earning 5%.
I can also plot this one, right?
So Here is the VOC.
Alright is this big enough for you to see
back there?
OK so VOC is up here and is 20 this is a
risk of a 40
And a standard deviation of 20.
Okay, so an expected return of 20 and a
risk of 40, right?

So those are two points.

But I can do other things too.
What if I borrowed money to buy Let's say
I have a hundred guilder.
I'm talking Dutch, okay.
That wasn't the currency of the time.
The guilder.
I'll write it for you.
Guilder.
okay.
So I have a hundred guilders to invest.
I can put it all in VOC stock.
And I will get I would expect to get
twenty guilders profit.
And I'd have a standard deviation of 40
guilders, right?
But what if I say, I'm going to actually
borrow another 100 guilders.
I only own 100 guilders, and I'm going to
borrow another 100 guilders and put it in
VOC stock.
So that means I own 200 guilders of VOC
stock.
And I'm going to have a debt of 100
guilder.
So what, what, what's my expected return
then?
Well, my expected return is going to be
35%.
Because look, I, I've got, I'm owner of
200 guilders worth of VOC stock.
The expected return is
20% so I'm going to get 40 guilders out of
that.
But then I have a debt, I've got to pay 5
guilders to my lender, so
it 35 is what I've got, and as
a percentage of my initial investment,
that's 35%.
So I've got another point out here.
With this is 35, and
down here is 80 See my standard deviation
is 80 guilders
now, right.
because I have $200.
And the standard deviation was 40%,
alright.
So this is, here I am two for one.
Two for one leverage.
I have $100 But I've, I've
I've put $200 in the stock.
Okay, and it's easy to do.
You know, you could do this in 1602.
so, you know,
you can see how I knew it.
I, obviously I can, I can, this is a
straight line here.
I could do anything along this straight
line.
And like, here would be putting half of my

money in the riskless asset and half into

VOC.
This would be putting 1.5, 150 guilders
into VOC and borrowing 50 guilders.
You see, I could go out any, as far as I
want.
Then there's another branch to this.
What if I short 200, 200
guilders of, of VOC stock?
Okay, so I go
to the broker, and I say, I want to sell
guild, I want to sell VOC stock.
I don't own any.
And the broker would say, alright, fine,
I'll lend you some shares and then
you can sell them and then, but you owe me
the shares, alright?
So then I have minus 200 guilders worth of
VOC stock.
So what is my expected return then?
Oh, meanwhile, by the way, the broker says
after you sell the shares,
I will get 200 guilders from the person
who bought them from you.
And I'll hold that and I'll pay you
interest on that, okay?
So, what do I get?
I expect to lose 40 guilders,
because i got $200, 200 guilders of the
stock.
But meanwhile, I've got my original 100
guilders.
And now I've got another 200.
And they're all there earning interest at
5%.
So I'll, I'll get 15 guilders.
So the expected return is 15
minus 40, or minus 25.
So that's this point down here.
But, you can see that you can also do
anywhere you like on that line.
So, what we have here is a broken straight
line.
I can get anything I want, right, this is
kind of obvious right now?
Anywhere I want on that line, on that
broken straight line.
And I'll, I, I can do that.
So, so here's where you got, saying, what
is the optimal portfolio anyway?
I can get any return I want.
You know, that my client who's asking me
to invest, says I want 100% return
expected.
You say, got it.
I'm no genius, right?
I'm just doing the most obvious thing.
Anyone who wants 100% return can get it.
I'm just going to leverage.
So, so that,

so this is what.
So then I create an investment.
If I have an investment company that
merely buys VOC stock and leverages it.
My investment company can have any
expected return that you want.
So this is what Markowitz was wondering
about.
Well, what does it mean to have the
optimal investment anyway?
And the core thing that he talked about in
1952, is.
There is no best investment.
There's only a trade-off between risk and
return
if we have to think about the best
trade-off.
And in this case, I've shown the trade-off
here.
It's this, this is what you can get.
And any one of those points is available.
And so anyone who Who wants to invest with
you has to choose between risk and return.
There's no optimal portfolio in that,
in a fundamental sense.
It's a matter of an optimal trade-off.
And you know, nobody knew that before
1952.
So
let me just show you formally this.
What I just did on the blackboard.
That, that you can say, we're going to
put.
I, I've switched to dollars from Guilders.
Now we're in the, in, in USA and so put
dollars in a risky asset.
X dollars in a risky asset.
1 minus x dollars in the riskless assa,
asset.
The, the expected value of the return on
the portfolio
is r is equals to x r1 plus 1 minus x
times rf.
Alright?
It's linear.
That's because that's how expected values
work.
The variance is x squared times the
variance of the return.
And so if want to write portfolio standard
deviation as a function of, of the
expected return
I solve for x.
Taking this equation for x.
Solve for x in terms of r.
So x equals r minus rf all over r1 minus
rf.
And then I substitute that in to this
equation.
Well, I want to take, I want to do it,

take the square root of it.

Because this is sigma squared and so I've
got sigma equals r minus
rf times r1 minus rf.
Well actually I have these absolute value
marks.
So I always take the if that's negative I
switch sign and make it positive.
So that gives the formula for this broken
straight line right here.
So that's pretty simple.
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