>> All right, so in this video,

we're going to talk about the Capital Asset Pricing Model, or the CAPM.

And this is providing a very brief recap of module

two of my first investments course.

So if you took that first course, this is just a quick refresher.

If you didn't that the course,

we want you to be able to join us in the second course.

So let's give you kind of a quick recap of what we did.

So first, let's just think about Simple Diversification and

when you're going to simple diversification, what do I think of?

I think of this old saying.

It is a part of a wise man...not to venture all his eggs

in one basket, from Miguel de Cervantes.

I'm sure I pronounced that wrong.

But hey, you want to at least bring the enthusiasm to the pronunciation,

author of Don Quixote in the early 1600s.

So does this kind of logic put out by the Spaniard here, does it make sense in

terms of thinking of portfolio composition in terms of kind of investments?

So let's go to the Variance of a Portfolio and look at just the simple formula here.

And we can start with kind of two assets and the variance of our portfolio

here is just going to reflect the variance of the individual components,

where this w1 and w2 are the weights given to these two assets in the portfolio.

w1 and w2 together add up to one, and

then also this interesting term here that goes to the variance of portfolio

that's representing the weights, the individual standard deviations, and

then this key term here, the correlation between assets one and two.

And then when you expand this to N assets, this variance of the portfolio depends

upon the individual variances or the individual securities in that portfolio.

But then also, all these terms here that are reflecting correlations

between the various assets that we have in the portfolio.

And as we'll shortly discuss, this correlation term here really becomes key

in determining ultimately the volatility of any portfolio we put together.

So after some algebraic pain, the punch line!

If we have an equally weighted portfolio, and let's just for

simplicity we have N assets, each asset gets 1 over N weight.

Here's what our variance of the portfolio formula gets down to.

So this is just some algebraic pain, assuming an equally weighted portfolio.

Two terms, kind of 1 over N times the average variance across all the assets

in the portfolio + 1- 1 over N times the average covariance across all the assets.

So, what happens is N gets large.

Well, the first term goes away and

the 1 over 1- N basically becomes 1, so the variance of the portfolio

really just reflects the average covariance across all the assets.

So, not putting all your eggs in one basket is good advice.

You don't want to have one stock in the portfolio.

As you go from one to ten stocks, you can reduce the portfolio variance a lot,

assuming these ten stocks aren't all in the same industry.

But once you get to a certain point, you don't really get the benefits from

the diversification in terms of lowering the volatility of the portfolio

because assets, all stocks, have some sensitivity to market conditions.

Okay, and we talked about that a lot in module

one of module two of the first investments course.

Okay, now let's take this logic and

think about this Capital Asset Pricing Model or CAPM.

The CAPM is really just coming up with benchmarks to determine what return,

different assets, different security, should return based on their risk.

And then the key part is to define, what do we mean by risk?

And in the Capital Asset Pricing Model setting, we view assets as risky

if their performance is sensitive to market-wide conditions.

So that's a fundamental contribution of the capital asset pricing model.

It provides a way to provide different benchmarks,

different kind of expected or required returns for

different assets and securities based on their level of risk.

And the risk is quantified in the CAPM by seeing how sensitive is their performance

to market wide conditions?

That's a capital asset pricing model in a nutshell.

And then the BETA of the stock is what matters in terms of setting

up these different benchmarks for different stocks, okay?