[MUSIC] After finishing this video you'll be able to understand the relation between risk and return, know the definition different types of risk. Understand the concept of Index Investing. >> Welcome, we're going to talk about the practice of investing. The first thing we need to discuss is the tradeoff between risk and return. In efficient capital markets there will always be relationships between risk and return Investment analysis should begin by considering these relationships. And then proceed to asses the extent of possible deviations of these relationships. Everyone wants return. Risk on the other hand, is a four letter word in the world of investments. Yet these two concepts cannot be decoupled. When you invest in an instrument or a particular asset class, you assume the inherent risk associated with that instrument, along with the expected returns that you may earn. Let's take an example to illustrate this point. Suppose you buy a share of Microsoft. Once you buy one share of Microsoft, you become a tiny owner of the company, 1 millionth, perhaps even 1 billionth, of the company. You become a residual claimant, meaning as an equity holder, you only get paid once the debt of Microsoft is serviced. Hence, the term residual, this share is a claim on the assets less the liabilities owned by Microsoft. But it uses in its business to make products and services. What could be the risks associated with owning a share of Microsoft? For one, its competitors could come out with a better offering of a spread sheet, or word processing program that buys the ubiquitous Microsoft Office out of market. Keeping all else constant, revenues would go down, profits would fall and so with the market price of a share you own. What is the probability of such a thing happening? What is the probability that a recession strikes? And all the major clients of Microsoft cut down on orders. On the bright side, what would happen if Microsoft comes with a version of windows that trumps all of its previous editions and its competitors in all aspects. How high could profits in the market price of the share you hold go? You invest your money in Microsoft expecting a return on investment. The hypothetical scenarios mentioned above, bring in components of risk or variability to your expected return on your investment. Your actual return will be very different from your expected return. This variability is the risk associated with Microsoft. In fact, the higher the variability, the higher would be the divergence of your actual return from the expected return. So how do investors minimize risk? An inequity investment, like the one cited comes with two kinds of risk. One specific to the stock and the other from the economic environment. We normally call these market risks and idiosyncratic risks. For example, let's look at Microsoft again, it has a management that takes decisions on future courses of action. A decision like the development of a new version of an operating system comes with a multitude of other issues very unique to a firm like Microsoft. Like what it's competition doing? How is the offering different from a competitor's offering? How would the market perceive it? Would it be a success or a failure? A firm in a very different area of business, you know say for example IKEA, the furniture company, would face a very different set of issues. Risks arising like this are what we call found specific risk and in finance jargon these are called idiosyncratic risk. The other type of risk comes from the environment in which the firm operates. For example, a recession has economy-wide ramifications. Growth slows down as the. Almost all firms get affected in a gloomy economic condition. During a recession, there could be cyclical declines in the value of stocks or firms that offer luxury goods. These kinds of risks that affect the economy as a whole or certain broad subsets of the market are termed systematic risks. Investors can minimize firm specific risks by investing in a wide variety of instruments across various asset classes. This act is called diversification. A very simple although naive type of diversification, would be diving the investable corpus, inequities, and fixed income instruments. Fixed income instruments provide a fixed streamed income, Irrespective of the state of the economy, providing a flaw to the portfolio. By doing this, the investor would've mitigated some of the risks unique to equity instruments. We now move to the ideas of sort of alpha and beta Ideally, an investor should invest in a wide variety of asset classes across a multitude of geographical locations that is he should have a global portfolio. At an ideal world if you can have a global portfolio with zero correlation you would get very good returns. Unfortunately, you can't get a zero correlation portfolio. What it can do is you can diversify across the globe. And once an investor has achieved such a diversified portfolio, you have almost eliminated firm specific risk, industry specific risk and possibly even country specific risk. We say, that the only risk that remains in a global market portfolio, global equity market portfolio is systematic risk An investor is typically compensated only for assuming the systematic risk of the market. This is because idiosyncratic risk can be eliminated or minimized by diversification. This is why in academic finance, diversification Is known as the only free lunch. All risk in a fully diversified Global Market Portfolio is market risk. If you could invest in such a portfolio, the return you would get over a period of time is the market return. This market return is often referred to colloquially as beta. Beta is the return you get from investing in the market portfolio. We will see that returns can be very good but we'll digress for a minute and discuss the fact that investors are often not satisfied with just getting beta. Investors want more return, and they want Superior risk adjusters. This is called alpha. Alpha is risk above and beyond risk adjusted return, above and beyond beta. If the market return over a period of 5 years is 10% and a certain investment manager has made 15% in the same period. You may attribute this express return to alpha and a fund manager would claim he has an alpha of 5%. Alpha can be generated, only if someone has an information edge or if someone has an investment strategy that can exploit market inefficiencies. In highly efficient markets where all participants are on equal footing, this is very difficult to achieve. So what can an individual investor with limited capital, limited financial knowledge and without any information edge do for his own portfolio? Let's now discuss individual asset allocation and the power of indexing. The investable corpus of most individuals is small compared to the value of the markets that we want to invest in. Additionally, we do not have any information edge compared to other market participants. And our investing activities have no effect on the direction of company specific actions. In such a scenario it might seem well nigh impossible to generate good returns, or alpha, and that is correct. But getting beta is an advantage return. Another important idea to keep in mind is that Alpha is a zero sum game. On average, the markets will give you the average return and if someone is making an excess Alpha return. Somebody else is loosing money by the same amount So a zero sum game you know you can get beta by getting the average. And alpha in aggregate has got to be zero. [MUSIC]
