All right, let's give an example of a scatter diagram. And I'm going to pick an example that compares the return on the stock market, or the overall market of all investable assets, with the return on an individual stock, let's say Apple Computer. Which I just picked because it's the biggest company in America. So let me just draw on the horizontal axis the Return on the Market. That's everything that you could invest in. We'll just imagine all stocks put together. And then on this axis we're going to put the return of Apple. And each point represents one year. So let's pick a year when the stock market went up, let's say, the market went up 10%. And what did Apple do in the same year? Let's say it did 15%. So I make a point here, a point above 10% and at 15% here. In some years the market goes down. Let's not forget that. So here, I'll say there was another year when the market did minus 5%. What did Apple do in that year? Well, let's say Apple did minus 10%. So, I get a point down here, you see this? This is -10, and this is -5. So I have a point down here. And than I can fill in many year, and each year is a point, and this is a scatter of points. I've got a lot of years showing. And now, when you see this, and some of them are negative or close to zero, when you see this scatter of points, you can say well I'm starting to see a relationship here that there is an upward sloping relation. There's a positive relation between Apple and the market. I can draw a line that's a best fitting line through the scatter of points, so that it kind of gets as close as it can to the scatter of points. That's called a regression line. And the slope of the line is called it's beta. If it has a slope of 1 that means the stock is reacting 1 for 1 with the market. But in the case of Apple, the beta is about 1.5. It's greater than one. The typical stock will just go 1 for 1 with the market. But this is a high beta stock. So it's reacting more strongly to the market. >> I see. So then the 1.5 you can see as if the return of the market goes up, the S&P 500 goes up 10%, then you should have 15% for Apple, which gives you the beta of 1.5 on average. >> Right, but it won't be exactly. It doesn't fall exactly in line. But they differ from the line, and that's called idiosyncratic risk. It's not related to the market, it's Apple risk. So the market could do great in one year. And Steve Jobs could get sick in that year. It's just something. So Apple didn't do well. That's idiosyncratic. The theory of the capitalized pricing model is that investors care more about beta than they do about idiosyncratic risk. because all these companies idiosyncratic risks will average out and wont matter. What matters is the systematic risk. The risk that correlates with the market. Those things do not average out not matter how many stocks you put in your portfolio. >> And so, is there any particular reason why some company x would have a high beta versus another company having a lower beta? >> Well, I think one reason, there may be many reasons, it's not just that this theory doesn't tell you why. I'm just adding some thoughts on that. One reason why Apple Computer might be a high beta star, is that it invests in projects that are iffy, that nobody's done before. And their success depends on the state of the economy. So, if they launch a new iPhone at a time of a severe recession, they're not going to do well. And the other thing that can make for a high beta stock is that the company borrows a lot of money. And then they're playing on the edge, because they have to make a lot of money or they'll go bankrupt cause they borrowed so much. Apple is not in that category, Apple has not borrowed a lot of money. It has, in fact, a lot of savings. That’s something that brings its beta down. But Apple is such a lively company, and so connected with what happens that their beta is still 1.5. >> I see. And so then a counterexample to this might be if there's a very low beta stock, so that would kind of look like either a lower slope or even a negative slope. >> Right, right. >> Okay. >> So for example, gold might in many cases be a negative beta stock. Why is that? Because when the stock market crashes people panic and they get upset, and they want to hold something very safe. At least gold it’s always safe in one sense, it stays gold. No matter what happens. It’s also something that you can run with. If you think that you're going to be a refugee, I want something I can stash in my purse and just get out of here. Gold has that aspect. So it's some psychological effect, that at least in some time periods, it looks like negative beta asset. And then, that would look like this. You have a a scatter diagram that looks like that. It's backwards. And you fit a line and it has a negative slope, you're going down rather than up. >> Okay, so that means that when the market is doing well, when the economy's doing well, gold might not necessarily be a great option in terms of returns. But then when we have a recession, that's when you see returns highest for gold. >> Yeah, and when constructing a portfolio it matters. Negative beta stocks help you in a different way. Maybe their return isn't so good on average, but they help offset market shocks. So, you'd like to have other things equal, you'd like to have negative beta stocks in your portfolio. As long as their return isn't so bad as to offset the advantage of their beta.
