ShmoopTube

Where Monty Python meets your 10th grade teacher.

Search Thousands of Shmoop Videos


Principles of Finance Videos 166 videos

Principles of Finance: Unit 1, Company Formation, Structure, Inception
97 Views

How is a company... born? Can it be performed via C-section? Is there a midwife present? Do its parents get in a fight over what to name it? In thi...

Principles of Finance: Unit 1, Intro: Company Formation, Structure, and Inception: Unit Intro
43 Views

Company Formation, Structure, and Inception: Unit Intro. Sorry, Leo DiCaprio fans—we're not going to be breaking down the plot of Inception. We'r...

Principles of Finance: Unit 1, Alex, That’s Finance Potpourri for $500
67 Views

Okay, so you want to be a company financial manager. It's basically up to you to make money for the shareholders. It would also be swell if you mad...

See All

Principles of Finance: Unit 6, Variance and Co-Variance 5 Views


Share It!


Description:

Everything you've ever wanted to know about variance and covariance, but were too afraid to ask.

Language:
English Language

Transcript

00:00

Principles of finance ah la shmoop variants and co variance

00:06

will human beings like to live in a calm financial

00:08

world We seek relatively low variability in our daily lives

00:13

least when it comes to our pension or retirement money

00:15

We've invested it's a lot of stress not knowing where

00:19

your rent money is coming from or if you'll be

00:21

able to feed your kids next month or if you'll

00:24

finally be able to buy a new car window to

00:26

replace that patchwork of duct tape So predictability in cash

00:30

flows and cash coming to you and reliability in your

00:34

long term retirement The quality of life you lead Yeah

00:37

that carries a big premium in our society We generally

00:40

want to mollify volatility And if we're thinking about our

00:43

personal investments well then we want good long term investments

00:47

But one who's variations offset one another at least a

00:51

little bit Well what does all this mean Well think

00:53

about a tiny tale of two industries the legal drug

00:57

industry and the washer dryer industry Vastly different characteristics here

01:02

But each industry is needed and it has a decent

01:05

place to exist for an investor for a long time

01:08

And there are good companies in each area worth owning

01:11

like what are the odds We still have colds and

01:14

dirty clothes in twenty years You know pretty good wealthy

01:17

economy generally goes long and its gentle booms and busts

01:21

over seven a ten year cycles ish that boom and

01:23

bust cycle greatly effects when people choose upgrade to a

01:28

new washing machine when times were good while they spend

01:31

the dough they buy when times are bad while they

01:33

just fix their old machine or try to find a

01:36

water polo player stomach to you know do the wash

01:38

on manually But when people are sick well they don't

01:41

care what the economy is doing They want the drugs

01:44

pain other than in certain video studios in van nuys

01:47

california is not optional They will pay up in good

01:50

times or bad for those legal drugs so drugs are

01:53

generally a steady state business good economy or bad they

01:57

grow up whatever percent per year they're going to grow

02:00

in the act more or less independently of what the

02:02

economy is doing So a portfolio that includes investments in

02:06

a drug company it's kind of stabilized by it it

02:09

just grows along at some modest percentage each year and

02:12

it doesn't have awesome years like the washing machine company

02:15

and it doesn't have terrible years like the washing machine

02:18

company just kind of goes along stabilize it But what

02:20

about a hedge What would be a direct opposite or

02:24

variant of washing machines Like what does well in a

02:28

bad economy Well how about a grocery couponing company Yeah

02:32

when times get tough people pay more attention to clipping

02:35

coupons to save money at the grocery store and that

02:38

business often booms when times are bad So the coupons

02:41

company is a co variant of the washing machine company

02:45

and note that all of these companies can be equally

02:48

good long term investments it's more about the long and

02:51

winding nous of the road that they travel to eventually

02:55

get there Five dollar word alert coefficient of variation Well

02:59

we have myriad choices in a portfolio we can put

03:02

together when we're investing and we'd better get on this

03:04

because loving rich old uncle ari is coughing a lot

03:07

more lately than he did six months ago Yeah we

03:11

may have big portfolios coming our way to build soon

03:14

We have a tool to help us figure out the

03:16

next level of granularity in the investment portfolio we're assembling

03:20

It's called the coefficient of variation and it maps the

03:23

amount of risk we took to produce a given investing

03:26

performance For example if we bought five dollars worth of

03:29

lottery tickets at seven eleven and we want one hundred

03:32

million dollars well what does that mean Well yes it's

03:34

great that we want We're gonna go shopping for yachts

03:37

and maybe a jet But didn't we take an insane

03:40

amount of risk to produce that lottery winning ticket like

03:43

it was one in a billion odds tto win and

03:46

we got that one in twenty million hitter there Yeah

03:49

well just because you're now rich does that really mean

03:51

you know what you're doing Is an investor Well financial

03:54

journalists will think so they'll talk about what a great

03:57

lottery picker you are because well you know history and

03:59

journalism is written by the wind right But really investors

04:03

will likely question your wisdom while they're separately lauding your

04:07

luck and leaving you to pick up the dinner check

04:09

and think about that we had like a one in

04:12

a billion chance of winning that lottery ticket So in

04:14

theory that five dollars quote investment unquote should have produced

04:18

a win of five billion dollars to simply equal the

04:22

odds but we only won one hundred million dollars in

04:25

the risk reward scenario didn't make any sense but we

04:28

did it and we want are we smart No lucky

04:31

ludicrously like insanely lucky so our coefficient here would be

04:35

extremely hi mathematically the coefficient of variation is just a

04:39

standard deviation divided by the expected return that thing remember

04:43

our rap album example versus just buying an index fund

04:47

You know if you don't go back and watch that

04:48

video please given almost the same expected returns we'll hopefully

04:52

the clarity obviousness of just investing in the index fund

04:56

is easy way better than the rap album for our

04:59

purposes here let's just ignore the details and how we

05:01

calculate the nitty and the gritty of standard deviation contextually

05:05

in a variety of portfolios and just cut to the

05:07

big idea here How to calculate the coefficient of variation

05:11

so you haven't expected return of ten percent from the

05:13

rap album with standard deviation of thirty percent i eat

05:17

lots of beta or volatility and potential outcomes like it

05:21

could go bankrupt and give you zero Or you might

05:23

make five times your money or a five hundred percent

05:25

return And in the index fund scenario you have expected

05:28

return of ten percent with standard deviation of only ten

05:31

percent So the coefficient of variation in the rap album

05:35

scenario is point three divided by point one or three

05:38

And the coefficient of variation in the index fund scenario

05:41

is point One divided by point once was just one

05:44

night Well easy choice now illustrated for you Mathematically at

05:47

no extra charge You go with the index fund and

05:50

you buy your self esteem enhancements with the cash you

05:53

save And maybe then you could just buy the rap

05:56

album on itunes instead and feel good about all that

Related Videos

GED Social Studies 1.1 Civics and Government
39794 Views

GED Social Studies 1.1 Civics and Government

Fake News
11938 Views

How do you tell fake news from real news?

Finance: What is Bankruptcy?
260 Views

What is bankruptcy? Deadbeats who can't pay their bills declare bankruptcy. Either they borrowed too much money, or the business fell apart. They t...

Finance: What is a Dividend?
1777 Views

What's a dividend? At will, the board of directors can pay a dividend on common stock. Usually, that payout is some percentage less than 100 of ear...

Finance: How Are Risks and Rewards Related?
589 Views

How are risk and reward related? Take more risk, expect more reward. A lottery ticket might be worth a billion dollars, but if the odds are one in...