[MUSIC] Learning outcomes, after finishing this video you will be able to measure the beta and alpha of an investment, split the returns for investments into three components. Risk and return. [MUSIC] The conventional view is that there is no free lunch. To increase expected return, you must increase risk. But actually there is one free lunch inference, diversification. So everyone should diversify, and so everyone ought to hold the market portfolio. Investing is global. Capital scours the world for the best opportunities. What goes on elsewhere of x India, what goes on in China and for the rest of the world. And competition is global. For example, is an American company. It's a very successful IT services provider for the majority of its employees. But diversification is not simply across companies or even industries in one market. Diversification what we practice globally. Your only domestic investors, Do not reap the full benefits of diversification, and expose themselves to a lot of risk. For example, if you're a Greek investor with a totally domestic portfolio how we would have done in the last few years. So according to the [INAUDIBLE] everyone can maximize expected return with the least expected list by holding the global market portfolio. That should be your base case, owning the global market portfolio is every investor's natural right. It gives the investor a perfectly fair share of the market's total return as well as the total risk. If the market goes up 10%, and you own the market portfolio, you make 10%. Making a portfolio like the market is easy. You can do it through index funds or index futures, you can even do it yourself. And the great advantage is that you don't need to do any research. So with this as background we arrive at a qualitative definition of beta. Beta is an investment that is a perfect microcosm of the entire market. It offers a perfectly fair share of a market's total return as well as total risk and it's extraordinary cost-effect. So what is beta really mean? If you like the risk return tradeoff in the market, you can invest 100% of your pork money in the market and your beta would then be 1. What is that too risky for you? You can immerse less than a 100%, leverage down as they say. Unlike in a portion of real portfolio to cash. In this case, your beta is less than 1. But if you want to higher expected return, you ought to be willing to tolerate higher risk. You may leverage up, and this can easily be done pretty clearly with derivatives then your beta is greater than 1. Once you select a level of beta, you have a certain expected return and a certain level of risk. So if you select a beta of 1.2 and the market returns 10%, then your return ought to be 12%. Now what if you wanted to increase your expected return, but keep your risk unchanged or what of you wanted to decrease your risk but keep your expected return unchanged? Now we go to the concept of alpha, a qualitative definition of alpha. Given your selected level of beta you will be expected to make a certain return. Alpha is the difference between your actual return and the expected return in your portfolio given your selected beta. The financial world has figured out that alpha is good. But they've not actually figured out what it actually is, whether there are supply constraints, how to get it and why it's good? So let's try and clarify some of these concepts. Beta and alpha, the risk of the market is shared between all participants. And it is shared based on the level of beta each participant has selected from himself. The return of the market is also shared between all participants. And the expected return is given by the level of each participant's beta. But the actual return of each participant is well the actual return they receive. And the difference between the actual and expected return for each participant is his or her alpha. The sum of alpha is equal to 0, in aggregate the sum of alpha must equal 0. The finite amount of return per unit of risk available in the market means that extra return received by one investor must be taken from another. This is an extraordinarily important point. Alpha must sum up to 0. Alpha is not generated, mined, or produced. It is taken from somebody, and it is taken directly from other investors. Now and forever the total alpha in the world will be 0. What are the implications of a 0 sum game? If the expected alpha is 0, and there are costs. What you realize is that you have to be smarter or luckier than other investors to get alpha from them. Yet there are thousand of funds in the world, all hunting for alpha, why? Everyone actually thinks they have some edge, and importantly they get paid to try. But one certainty is many, many of these will end up being alpha providers. Alpha is wonderful, alpha is wonderful. Alpha is technically excess return with no excess risk literally, free money. Of course, in reality there are risks. And risk is that you actually got negative alpha. But alpha risks are unique and very different from market risk. Beta risks are earnings, GDP, macroeconomic. Alpha is so desirable, because it comes from taking something different from market risk. Real alpha shows perfect immunity to even the worst market crisis. An alpha is literally the single best thing you can add to any portfolio, because it has zero correlation to anything. So now let's examine alpha with a few pictures to try and reinforce all of this concepts that we've just gone through. We understand that beta is that return that comes from the market and alpha, is that which comes from somewhere else. Either a good model or manager skill or luck. [MUSIC]
