Risk and Diversification - Video Tutorials & Practice Problems
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Market Risk and Firm-specific Risk
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So let's go into a little more detail about diversification and the types of risk that we see in the market. So we've talked about risk a little bit, right. And that all has to do with uncertainty, uncertainty in the market And that's uncertainty regarding the future. Right? We don't know whether we're gonna make or lose money. So we're taking on risk when we buy an investment. So we talk about diversification as well, right? How do we get rid of risk is through diversification. So we're reducing risk, we don't get rid of it entirely. We reduce risk by replacing a single large risk, let's say buying a whole bunch of money in one company. You know, you buy like 10,000 stock in one company. Well, what if you bought 10 pieces of stock in 1000 different companies instead? Right. You're gonna take smaller, unrelated risks. That is diversification. So that's the idea. How do we diversify is to hold a large number of different investments rather than just one investment? Because if that one investment tanks you're screwed. Right? But if you hold a bunch of different investments, if one of them tanks, well that wasn't all your money. Right. Other ones will go up. Things like that. So when we talk about risk and diversifying risk, there's two types of risk, we think about, we think about firm specific risk and market risk, firm specific risk is risk that only affects guess what one firm? It's specific to that firm. So what would be an example of a firm specific risk? Who it might be things with their customer base, their competitors, right. Things that affect that firm specifically. So those would be firm specific risks and those types of risks. Well, they can be diversified. They can be diversified. You can diversify away firm specific risk by buying a bunch of different firms that have different firm specific risks and sometimes even opposite firm specific risks that offset each other. Okay, so those risks that affect only one firm, you can diversify them, compare that to a market risk. And this is a risk that affects the whole market. So a very simple example would be something like a recession. So if there's a recession or maybe let's add like a war, you know, war, the country goes to war some act of terrorism, something that affects the entire market. Well, you can't really diversify that away because everything is gonna drop in that situation, right? During a recession we kind of see everything starts to fall. So you cannot diversify market risk. So that's the risk. That's less left over. Right. You can't diversify the market risk, but you can get rid of that firm specific risk. So overall you have less risk, right? Think about someone that just owns one company, right? They just have all of their eggs in one basket. They have firm specific risk and market the market crashes and the the customers leave that market for another company. Well that company's screwed and it's double screwed because of the market risk as well. But if you own a bunch of little things in different companies, well, the firm specific risk can be diversified away. Alright. So why do we take these riskier investments? So why would you ever buy a piece of stock rather than just putting money in the bank or something? Well, it's because you're expecting a higher rate of return. Right? Let's say you go to the bank and you're offered 1% interest if you're lucky these days, right? You're offered 1% interest. Well, you might buy a stock because you can think you can make 5% 10% on your money. Right? That would be the risk you're taking to earn a higher return. So when we talk about the risk of an investment, we have to compare it to a risk free investment, right? Because if we're going to take on some risk, well, it's gotta pay higher than a risk free investment, Right? So risk free investment is the return on an investment that has no risk. Okay, so a simple idea would be just putting money in a bank account. But generally when we talk about a risk free investment, the common thing that we think about is us Treasury Bills, Okay, Bills or notes. Anything that the Treasury sells is generally considered to be very low risk or risk free. Okay, Because that would be the idea of the U. S. Government collapsing and then those bonds would fail, right? Those those investments would fail. But other than that you're safely expecting to get that money back. So whatever those those investments are paying well, you better make more than that if you're gonna take on risk, right? Because why take on any risk? If you could just buy the risk free investment to make the same amount of money, you might as well take the risk free investment. So in the case that you're going to the stock market to buy stock, you should expect to make more money than the risk free investment. So we calculate the rate of return. Very simple. A rate of return is just the income, the money that you make divided by the price. And generally when we think about income, it's either gonna be dividends. Capital gains. In the case of stock, we would have dividends and capital gains. That would be in the case of stock or in the case of like a bond we would have interest, you would earn interest, that would be in the case of bonds. Okay, so that's the income that you make. Um Let me get out of the way. Just so you see that over the price, the price you paid what you paid for the investment. So what you made divided by the price that is the rate of return of that investment. Cool. Alright. So nothing too crazy here, let's take a pause and we'll talk about one more thing related to risk and diversification.
2
concept
Efficient Markets Theory, Random Walk, and Irrational Behavior
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4m
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So when you go to buy a piece of stock on the market, a share of stock, how do you know that the price is correct? Well, you don't really, But what we have is the efficient market hypothesis. And this is the idea that the price that we see on the market is taking in all available information about its value. It's hard to talk and write at the same time, all publicly available information Is going into that value. So when you see a share of stock and it's worth $50, that's because all the news reports, all the financial statements that have come out, people have made valuations and they expect it to be worth $50. Now, is that true or not? Well, let's go on a little bit more about this theory. First of all, that under this hypothesis hypothesis, the markets are said, to to exhibit informational efficiency, because all information is reflecting in the price. Right? It's efficient with the information that's available is getting into the price. And what we see is that stock prices change when new information becomes available. That's why you see analysts readily waiting for reports to come out for, for stockholders meeting, where the company is gonna tell about the future plans of the company and what they're expecting to do. Well, that's going to affect the stock price because it's new available information. And now, for that information to be new. Well, naturally, it must be unpredictable, right? If you could predict what that information was. Well then it wouldn't be new. It wouldn't be, uh, it would have already been included in this available information, if you could predict it. Right? So that's the, that's the whole key here with the the efficient market hypothesis is that these these uh investments are going to be unpredictable and therefore follow a random walk. So when we think about, when we see a stock price, when you look at a stock graph, it looks like this, right? It's just like someone's crazy heart chart that that's having some sort of spasm in their heart. That's what, that's what the chart looks like, right? And it's a variable that it's impossible to predict. So people who try and say, oh, this stock has been going up in price. So naturally it's going to continue to go up or they they look at historical data to gauge what's going to happen in the future. You can't really do that with stocks because that's the whole idea with this hypothesis, is that that random walk, that that path that it's been taking is basically dealing with this change in information. However, when we think about this efficient market hypothesis, it's not taking into account one thing, our people completely rational, when they invest in the market, think about all these bubbles that we've had, there's all sorts of bubbles in the real estate market, the real estate market in in the Great Depression, excuse me, great recession of 2008 kept rising and people would keep buying houses and selling houses and they were just trying to make a quick buck because of all of the gains in the real estate market or the dot com bubble of the late 19 nineties, right? Where people were just buying any website just because it had a dot com after it, they knew it was going to make money so they would buy in and just hope to get out before anyone else does. Right? So this idea of speculation, people are just speculating, they're basically gambling that these things are going to go up in value. Well, they that's going to affect the price as well, right? Um, if a lot of people are just buying things just because everyone else is buying it, right, Everyone else is buying real estate. I want to make money to this idea of fomo, right? The fear of missing out. They want to make that money to everyone else is making money. I want to make money too. So that's going to inflate the price and eventually that bubble will pop and a lot of people will lose the money, everyone who's still holding it will lose, lose out in the end. Cool. So that's the idea of this efficient market theory and how it doesn't totally work out because people aren't always completely rational and sometimes are just focused on making that short term quick buck. All right, let's take a pause here and let's move on to the next
