So we've learned about the importance of investing. Right now, we're going to learn about the rules for investing and these rules are kind of important. They help us to understand what's possible and what's not, and why investing really is different than gambling. So the rules that we're going to kind of think about are risk and return, diversification, asset allocation, and information and investment decision making. So let's break some of these down. Now, risk and return. This is something we've heard a lot of. In general, the more risk you're willing to assume, the greater the expected return. And, in fact, how much of this risk we're willing to take on we know now is tied to our overall level of risk tolerance. Now, here's an interesting point though. The market is not designed in such a way that it rewards you for taking unnecessary risks. So, if we think that just picking a stock and putting all our money on it is investing, that's more like gambling. That's highly speculative in nature and that's really not what's going to happen. So, we're more interested in the idea of prudent investing and also realizing that when we talk about risk and return, there's more than one type of risk. So, there's two major types of risks actually that we're going to call, systematic and idiosyncratic. Let's start with systematic risk. This is the risk that in, affects really all investments as we understand them. And these are risks that we kind of think about at the macro level. Inflation risk, prices going up, affects the cost of inputs, affects most companies and many companies. Also affects the amount of money consumers have to spend as a result. Interest rate risk, right? As interest rates rise, especially from the Federal Open Market Committee, we know that the value of securities in general tends to go down. And again, that affects the majority of investments at one level or another. There's economic risk, which we can often think of as cyclical in nature, whether we're in a recession, whether we're, of course, in a, in an expansion phase. And again, we're not going to suggest every investment face these risks the same, but rather that every investment faces these risks. And then there's things like political or market instabilities, especially for a lot of our multinational companies, that sometimes challenges that may happen overseas may often affect what's happening on a broad level for us. Because these risks are systematic in nature, we often refer them also as non-diversifiable, meaning that it's really challenging for them to eliminate, to be eliminated, from our entire portfolio. Now let's take a look at idiosyncratic risks then too. These are more firm-specific in nature and they include things like default risk, financial risk, and country specific risk, as well as even sector specific risk. So, these are things that are very unique, sometimes to one firm or even a small subset of firms. So, great examples are thinking of new products that are coming out anytime soon. You might have heard them, whether they're gaming systems, new types of technology. Some of them do really well, some of them fail miserably. The fact that one of them fails miserably typically has an isolated effect to that firm. So as a new cell phone maker comes out and blows all the others away, that company does great, right? A company that really falls off and has obsolete technology, they may go away. Maybe companies that were working with them may have challenges, but it doesn't affect others as a whole. So this is a whole host of examples we can see across history, really that show us how this type of risk comes into play. Because this risk is unique, it can be isolated in investments and can be offset with other investments. So, for example, having a company like Apple in your portfolio. Well, that has unique product risks associated with it, but has very little to do with Nike, or Proctor and Gamble. And so, for example, as we might have one company in there that's a technology company, we might offset that with other companies that have nothing to do with it. And that's how we can diversify. So that's how we deal with this idiosyncratic risk. So when we think about how do we measure risk, well, there's two common measures we hear about. And these are in a lot of newspapers as well as a lot of news shows, so I think they're worth mentioning. Beta is a commonly used measure of this systematic risk and it's re, derived from a lot of analyses that are being used to look at how investments relate to the overall market that they're in. And so, for example, a beta of one tends to imply that a stock moves in general with the market. The market goes up, the stock goes up in a similar proportion. Not identical, similar. Standard deviation is more about total volatility, so it's a more true measure of risk because it account for what would be the systematic risk and then also the idiosyncratic, or non-systematic risk. So, diversification then is really the idea that we're trying to manage the idiosyncratic risk. One thing that we kind of want to hit on now at this point, that idiosyncratic risk is not what we're rewarded for. Taking that on, putting our eggs in all one basket sort of flies in the face of what we're talking about with these modern investment principles. So, the market doesn't reward us for assuming this idiosyncratic risk. In fact, it's the opposite, right? We expect to be rewarded when we have a diversified portfolio that assumes systematic risk. So, diversification really is reducing investment risk by offsetting different types of investments against each other. So, we can only really then diversify this idiosyncratic risk. So let's take a look at sort of the relationships then between risk and the types of investment. So we'll start off with the risk-free investment over here, the treasury bills. We move on up and think of money market securities, intermediate, large corporate stock, small corporate stocks, real estate, foreign investments. So what we see is that we go from having no risk to taking on a lot more risk, but also having a lot more expected return as a result. The security market line does assume that we're dealing with a diversified set of investments though. It's not to say that if you have any one of these, you would see this pattern. If you had one T-bill, one, one short-term debt, one large stock, one small stock, if you just stack them all up, you might not see this pattern because that's not the intention of the SML, right? The intention is to understand that in diversified portfolios, we might often see this pattern and it's what we typically have seen over time. Now, let's look at diversification then, illustrated if you will, and this is from one of my favorite books by Herbert Mayo. Right, if we take a look within here, we have the number of securities on the bottom and, of course, on the upper axis, the y-axis, we have risks. So what we see, right, is that a curved line, right? So if we look at line CD, the curve that's happening there, we see that that represents the line under which we have the total portfolio risk. Now, remember, portfolio risk was separated into two components, systematic and unsystematic. So the systematic risk, you'll note, right, the line, the top line AB doesn't change. So, regardless of the number of securities we have, AB stays a flat line across. Meaning that the diversified, the non-diversifiable risk really doesn't change no matter what we do. We're going to be exposed to it. When we're exposed to it, that's going to be a good thing, right? Because it means we can expect a reward, assuming we're diversified. But note what happens to unsystematic risk. The greater the number of unrelated securities that we place into the portfolio, the more we reduce and virtually eliminate unsystematic or diversifiable risk. Now, I say virtually because, mathematically, it's probably never going to actually go to zero. But it does mean that we can really reduce the effects that we would see so that no one investment can be truly devastating to our portfolio. But again, an overall market downturn is still going to hurt us. So that's going to be hard to avoid. Now, it's important that we also get a sense of these overall investments. So when we look at how companies respond and what their overall growth is, why do we need to have asset allocation? So, asset allocation is partially how we're going to achieve diversification because not only do we want to have a bundle of the different types of assets, if we're mostly in stocks, we need to be in a broad number of stocks. If we're mostly in bonds, we need to have a broad number of bonds. So, as we look through these, it's important to kind of note why it's so important to build these up. Let's say that in 1925, you went out and bought $1 of goods, an apple, an orange, maybe some bread and some milk, and that cost you a buck. Well, in 2005, for example, that would have cost you $11. That's a 3% rate of increase over that 80-year period. Now, why do we use that as a benchmark? Because remember, we talk about how things perform above and beyond inflation. Something that doesn't beat inflation is going to be challenging because we're actually losing money from year to year. So let's see what happens. If we go with the risk-free investment of the treasury bill and we invested $1 in 1925, that would've grown all the way up here to $18. And that's about a 3.7% rate of return. So it beats inflation, not by much, but it's risk-free. So there was no chance we wouldn't get our money is the idea. Let's say we put it in government bonds, and right, bonds are going to be longer term investments from the government as well, so these might be ten years, 20 years, 30 years. And so $1, right, from 1925 rose all the way up to $71, about a 5.5% rate of return. So, we're keeping pace with inflation, but let's see why asset allocation's really so darned important. Because $1 invested in 1925 in something akin to say the S&P 500 grew to $2,600 over that 80-year period, a 10.4% rate of return. And small company stocks, right, if we were betting on the growth side of things. That was over $13,000, right? And over 12% rate of return. This is why it's so important that we mix up our assets, because these lower returning assets obviously are highly stable. They're fixed income in nature. So when we have shorter time frames, say, periods under 12 to 15 years, we're going to certainly need to have a balance of our investments so that we're not putting too much in the overall volatility of the stock market. On the other hand, the longer the time frame we have, the more we want to take advantage of that volatility because in the long run, it works out in our favor, periods of 12 to 15 years or higher. So, we've often heard the phrase invest in stocks for the long run and that's because the growth that stocks will provide when we give them enough time to even out their volatility is actually going to out, way out perform some of the other investment options we have. However, in the short run, we simply can't be as certain of having that protection or having that stability. So, asset allocation's really important. We need different things from our investments. Sometimes we need growth for our future goals and equities are going to give us more growth than other investments. Other times, we need liquidity, things like short-term assets in nature. This can be savings accounts, money market accounts, short term CDs, even T-bills, which are at most 90 days. And then we might also need things like income production as well. This can come in the form of bonds that might pay regular annual coupon payments. Or it could even of, course, come from high dividend-paying stocks. So we'll think about what our needs are and realizing that what we need from an investment portfolio changes over time. When we're younger, we tend to be more focused on needing growth. As we get older, we might need some elements of liquidity and income production. And in retirement, we're certainly going to need a mix of liquidity, income production and growth. And so that's why we often say, you know, the older and older we get, the more complicated investing actually gets. Not just because we potentially accumulated more money, but because what we need from our portfolio gets more and more complex. Now, let's say a word about all these rules we've talked about before. Despite these rules, people still have the assumption that somehow they would beat the system, that they would game the system. Now, let me point out this first fundamental fact, never more true today than it ever has been before, right? Everyone has access to public information. It's all over the internet. You can pick up the phone and call people. You can pick up a newspaper. Everyone has access to pubic information. And companies that are publicly traded are required to disclose this information. Which means, in general, we're probably not going to know something about a company that everyone else doesn't know. A company's got a new product coming out, everyone knows that. Analysts know that. And, in fact, if you know something that everyone else doesn't know, it's probably because you have an inside track. And that inside track, using that information, is also referred to as insider trading. And, in case you're not sure, that is illegal, right? And pretty unethical for that matter. So, a few things to know about what we call the efficient market hypothesis. No one beats the market consistently. When we say beat the market, what we mean is whatever something like the S&P 500 does, that's kind of what we talked about the market's performance, however that's doing it. Most of the time, we don't beat that. We should expect, right, that anticipated public information may affect prices. So, for example, if we all know something's coming, we can expect prices will reflect that information, so it makes it really hard to outperform. This doesn't mean there's not surprises. So, for example, if you follow companies, you'll see things like, oh, we had a positive surprise today. A company's earnings came out and they were higher than everyone predicted. So those positive surprises can still catch investors off guard. So can negative surprises, somebody comes out with information we didn't expect. And this can be true for company specific information, or macroeconomic data such as how job performance is coming in our labor markets, right? Is unemployment going down or going up? So these types of things, if they're what we anticipate, don't greatly shock the stock market. However, things that we didn't anticipate or that are different than our expectations can sometimes introduce an element of surprise. So, what's the role of information? Well, again, we should act on things that are prudent. We just shouldn't expect that it's going to get us to outperform any investments. So what does that mean about things like fundamental analysis, or the analysis of company data, and technical analysis, where we're charting and looking for patterns, for example, in the pricing? Well, some will say that there's some merit to that. And certainly, value investing, which is based in part on fundamental analysis, does pretty well in terms of an investment model. That said, it does fly a little bit in the face of the efficient market hypothesis. The most str, widely accepted form of the EMH, if you will, is called the semi-strong form and it simply says that all public information is reflected in the current price. So, think about, then, the implications for this. Everything that we can know about something that's out there is already reflected in today's prices. So do keep that in mind as you're making investment decisions even if you think you know something more about an industry than the average bear does, chances are we don't know as much as the people who are spending 40 hours a week getting paid to cover that industry. So, let's recap. Savings and investing, as we learned last time, is very important. What we've learned this time is that there're specific rules that govern savings and investing, and that affect investment markets. And ergo, we should embrace these a little bit in our investing philosophies, investing in growth for the long run, investing in diversified portfolios. And we're going to see, as time goes on, that there are mechanisms then to help investors with this diversification. So, tune in next time. We'll learn a little bit more.
