[MUSIC] Learning Outcomes. After watching this video, you'll be able to understand what risk and returns are and what do they mean. You'll also know how risk can be reduced by diversification. Building a stock portfolio is easy. But building a successful portfolio is a challenge even for the smartest of traders on the Wall Street. Investors are often overwhelmed by the large amount of stocks which can be even more than 100,000 stocks that trade on different exchanges all around the world. So if you have to navigate through a plethora of stocks, which are essentially opportunities for investments, and you also have to navigate through risks, through timing issues, and a lot of other uncertainties. So building up successful portfolio is, in my view, is part art and a bit of science. In fact, it's probably half, half. It's half art and half science. The art part is in the market and stock timing as we have discussed in the early lectures. The science is in how to maximize your returns with as less risk as possible which is what we'll discuss in this lecture. So risks and diversity reward and diversification,, these are some of the most important concepts that we need to understand before we start our portfolio. There are factors that come into play in all investment decisions. Investors need to learn a little bit more than just the textbook definitions of these factors. And you need to understand how they, in conjunction with market timing and business cycles, affect portfolios. Even risk, when properly managed and understood, can even help your portfolio. And there are different levels of risks and different types of diversification. Simply put, risk is the term that is used to determine the volatility or the uncertainty of your investment results. So this typically goes hand in hand with returns. The more risk you take, more often than not, the higher is the expected return. Conversely, the lower the risk you take, the lower the risk of the return. When we say return, it generally means profit. In the investing world it's usually expressed as a percentage and is often annualized. For instance, if you're investing $100 and getting a $6 profit in, say, a couple of years, you have a return or profit percentage of 6% and an annual return of 3%. If you're investing $100 and making, let's say, a $50 profit over two years, that's 50% return over two years and an annual return of 25%. To understand, that was return, so let's understand risk now and risk tolerance. So to understand risk tolerance, let's look at a very simple example that I often give to my friends. Let's say there are four friends, a, b, c and d, and let's put some name for that. Let's call them A for Adam, B for Bob, C for Charlie and D for David, okay. And let's say each of them have very different ways of investing their money. And let's say each of them have $100 in their pocket and they want to invest it in their own ways. And they invest differently because they have very different levels of risk tolerance. So let's say Adam is extremely risk averse, and keeps his $100 in his pant pocket or keeps his cash in an old jam jar. I mean, he sleeps very soundly knowing that he will always have $100 in the jar because it can't go anywhere. Then you have Bob who is also risk averse but he deposits his $100 in, let's say, a money market account at the biggest bank, the oldest bank in town. And that money market account pays, say, 1% and Bob is positive in 12 months and he'll have essentially 1% on $100 which is, he'll have $101 in that account. The third guy, Charlie, he likes to take some risk, and let's say he bought $100 worth of IBM shares. He researches the stock and discovers that, over the last ten years, IBM's annual return has varied from, let's say, negative 10% to a positive of 50%. So he is somewhat confident that his $100 investment will turn in somewhere between say $90 and $157, minus 10% and plus 57%. The fourth guy, David, his broker friend, he has a very curious way of investing. And let's say his broker friend has tipped him about a stock, let's call it XYZ, and it's a barter company. This barter company has run, say, some preliminary tests on a drug that seems to be curing cancer patients. And it seems to cure six out of ten patients that it has been tried out on. And now they're planning a larger test with, let's say, 1,000 people. And David's broker says that if the second test has similar results as the first one, then the stock will pop from $1 to $100 over the next year. And if it doesn't go well then the company's bust, it's out of cash and will likely have to fold. So David buys $100 of shares of this company XYZ at $1 hoping that the stock will at least become triple or become ten times. But he also know that there's a lot of chance, a very high chance, that the company will be bankrupt and he will lose his investment. Obviously, these are four different personalities with four different risk tolerances and with four different return expectations of what they're going to get. Since none of us have a crystal ball and so we don't know, and none of those friends also know what their final return will be in a year. For instance, Adam might mistakenly you know essentially put his bag in the laundry and that $100 may get washed up. Or he may throw away the jar because he forgot that he put $100 there. Bob's bank could discover that its funds were stolen by a malicious Ponzi scheme. Charlie's IBM stock could turn worthless if a company collapsed, like if IBM collapses like ENRON. And David's bet on XYZ stock could be worth either 100 times which would be 10,000 or nothing which is 0. So a primary Investment goal for all investors is to minimize risk, and diversification is the most reliable way of doing so. Diversification essentially means spreading risks around so that all your eggs are not in the same basket. Your home or car insurance works much the same way by spreading individual risks between everyone who pays their insurance premium. But suppose the four friends have a fifth friend, let's call him E for Edward, who can't make up his mind as to what to do with his $100. So he adopts all the four strategies at the same time. So and thereby diversifes his $100 by investing, say, $25 in each of their styles. He keeps $25 in cash. He keeps $25 in money market accounts. He keeps $25 in a blue chip stock, which is a low risk stock, and $25 on a riskier, potentially high return biotech investment. Mathematically, diversification is about minimizing the variants in your returns by averaging the expected returns of each of your stocks. So if stock A has a return of minus 50%, the 50% a year and stock B has a return of, say, minus 10% or 10% a year, plus 10% a year, then it would make sense that a portfolio that was 50% invested in each of these stocks would expect to have returns between minus 30% to plus 30%. Now if you add stock C which always returns 5%, then a portfolio which is equally weighted between A, B and C would have expected returns between minus 18% and plus 22%. So now but if I can put, let's say, 50% in C and 25% in each A and B, then we are at minus 13% to a plus 8%. Now suppose that we add a stock D to our portfolio which moves opposite to stock A. So when stock A loses 50%, stock B is gaining 20%. And if stock A is gaining 50%, stock B loses 5%. Our equally weighted portfolio of A, B, C and D now has expected returns In the minus 9% to plus 15% range. So we can average out returns by buying different stocks. But the most important way to diversify is across different industries, different sectors, and different geographies so that each of our stocks doesn't perform at its worst at any point in time. [MUSIC]