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Principles of Finance: Unit 6, Weighting Averages and Expectations 9 Views


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Weighted averages & expectations are all about odds; the odds of getting paid back, the odds of making it in the NBA, the odds of...watching this whole video.

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00:00

Principles of finance ah la shmoop waited averages and expectations

00:06

Alright us oddsmakers a big theme in finance What do

00:10

you believe The odds are that your body will pay

00:13

back the loan you just made her What do you

00:17

believe The odds are that you'll get into a car

00:19

accident on the way home from dinner tonight What are

00:22

the odds that this drug cures cancer instead of just

00:26

you know making hair grow on your knuckles Well you're

00:29

going away odds and give numbers when you calculate outcomes

00:33

The big challenge here bias if you ask ten thousand

00:37

varsity all star high school basketball players in the u

00:41

s iea about all of the all stars what they

00:44

think the odds are that they will turn pro and

00:47

play in the n b a We guess about twenty

00:50

percent of them will say fifty fifty So what is

00:53

that number impute Well it means that half of the

00:56

twenty percent or ten percent will turn pro and play

01:00

in the n b a That means that based on

01:03

your sample ten percent of ten thousand or one thousand

01:07

varsity all star high school basketball players in the u

01:11

s just this year will turn pro and play in

01:14

the n b a And given that there are only

01:17

about five hundred total players in the n b a

01:21

it would be truly striking if more than double that

01:24

number in a single year ended up being on the

01:26

floor Yeah so what's the problem here Yes biased high

01:30

school athletes are knuckleheads when it comes to separating reality

01:34

from dream don't you wish you still had that love

01:37

in your life All right well the reality here is

01:39

that in a given year about ten high school students

01:42

who play varsity all star hoops actually make it into

01:45

the n b a and play for a little bit

01:48

in the pros The odds are good that if you

01:50

put all your eggs in the pro basketball basket well

01:54

it won't end well See the section of shmoop that

01:56

covers careers as a high school basketball coach physical trainer

02:00

and uber driver and delivering pizza Teo you know pay

02:04

your rent all rights let's hang up our sneakers for

02:07

now and think through an investment case being a rap

02:11

star who actually makes meaningful money comes with about the

02:15

same odds as being a successful n ba player But

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at least in the n b a you make serious

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money and for more than just the one or two

02:23

years But we're not here to give career advice per

02:26

se So let's start by looking at the numbers here

02:29

looking an album here and what the album does All

02:32

right so we have a rapper's album That's gonna have

02:35

different outcomes Different levels of goodness Different levels of money

02:40

Note here that the odds have tto add up to

02:42

one hundred percent You have to have invested your dough

02:46

fully there So these numbers are kind of odd Your

02:49

odds adjusted financial return here investing in this rappers album

02:54

everything here's the man You all right You know they're

02:57

they're here Well should you fund this album you get

03:00

fifty two percent What do these numbers mean anyway The

03:03

data is saying that the most likely outcome is that

03:06

you make just over half your money back So why

03:10

on earth would you put in a dollar when the

03:12

most likely outcome is that you get fifty two and

03:14

a half cents back in years later Well with an

03:17

expected return Less than one note how we conveniently ignored

03:22

time value here like you held it for five years

03:25

in an index fund I almost double your money or

03:27

at least get closed All right Well this investment on

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this rap album is an easy pass So then what

03:33

would not be an easy past kind of investment Like

03:37

what Hurdle rate Yes hurdle rate Would you need tohave

03:40

that's greater than one that would then tickle your fancy

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to find your pen and sign your john hancock and

03:45

take your hard earned money and invest it Ignoring time

03:49

is dangerous There we'll come back to that All right

03:51

well but in this case what if we believed in

03:53

america capitalism standing in respect for the flag An apple

03:56

pie Well if that's the case then we've comfortably invest

04:00

in stock market and hold for long periods of time

04:03

like just buying index fund and go play golf So

04:05

let's believe that the market in this era will go

04:08

up about ten percent a year We still really want

04:10

to be an investor in the entertainment biz and rap

04:13

albums you know because our self esteem is low and

04:16

we need the hottie bling to make us feel special

04:19

What multiple of our investment do we need to recoup

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in order to meaningfully beat our and percent a year

04:25

hurdle rate in five years Well we start with the

04:27

base case of the market And if we invest a

04:29

dollar today than in five years it should be a

04:32

dollar times one point one of the fifth power or

04:34

about a buck sixty Well how can we make the

04:37

outcome of our rap album investment mohr likely positive Well

04:42

what if we cut a nice distribution deal with read

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it Who guaranteed us five hundred a emma's a week

04:48

for a month You know that tickle people's fancy give

04:51

us distribution awareness Maybe a little brand Well then all

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of a sudden the likelihood of the album being a

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hit goes way way up in the new tables Look

04:59

like this Yeah And the album's not gonna kill people

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here right here in the Numbers in the 1:3 5 there

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we go all right well note that a few things

05:06

changed with the red it guys now marketing us well

05:10

the odds of the album inspiring young people that actually

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do bad stuff went down The high end went higher

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We make five times our money for a chart topper

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instead of three times And the odds of just getting

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half our dough back went down slightly Well here's the

05:24

new expected return You here's the math We're gonna win

05:26

one point a point You have five minutes Use all

05:28

the odd close but no cigar will be expected Return

05:32

on this investment in five years is one point three

05:35

five acts But in order to drive a ten percent

05:37

return well we need one point Six x or mohr

05:41

And remember investing in the stock markets probably a whole

05:43

lot less risky and investing in a rap album Well

05:46

what if the investment happened over a three year timeframe

05:49

I eat The album was produced and distributed much faster

05:53

instead of that five year plan Wealth than our new

05:56

hurdle rate is one point one two the third day

05:58

at one point three three that's kind on the market

06:01

would compound their magic Well in this case the expected

06:04

return on the rap album is just slightly better than

06:08

out of the stock market That is one point three

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Five Acts beats 1 . 3 3 at least in america so should

06:13

you invest is the rap album a better deal than

06:16

just buying an index fund of the s and p

06:18

five hundred no in oh absolutely not even though mathematically

06:24

you have calculated above that it is well why risk

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note the volatility in the rap album scenario you have

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seventy percent odds that you lose half your money you

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have ten percent odds you lose all your money and

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maybe go to jail as well among other life negating

06:40

issues you only have a twenty percent shot of making

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five times your money in three years and by the

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way if you like playing the lottery that way well

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there are tons of public company stocks that go up

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five times in three years all the time if you

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just go bet on those now consider the stock market

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scenario what are the odds the market ends up being

06:58

worth zero well that would mean the world's been fully

07:02

nuked and there are no humans left including you so

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you'd have other things to worry about him that were

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the case or actually you'd have nothing to worry about

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because you just be well dead or a zombie or

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something And what are the odds of the market going

07:14

down Fifty percent Well in all history the market hasn't

07:18

had that size correction but twice and it came off

07:21

ridiculous bubble highs highs everyone knew were crazy and the

07:25

correction didn't even last very long But remember the one

07:28

hundred times revenues multiples late nineteen nineties internet boom Yeah

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that kind of crazy that's what we're talking about here

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So the odds of the market being cut in half

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are awfully low but even if it was in your

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patient five years later it would likely have recovered teo

07:42

just being flat So what's ah five year old rap

07:46

album worth Yeah not a lot Well the concept we're

07:50

getting at here is called beta beta is the standard

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by which enormous investment decisions are made in veda is

07:58

contacts you'll meaning that it means something different two different

08:01

people think of it as the religion of risk Well

08:05

let's quantify some elements and newsome dissection of beta there

08:09

Alright what's odd about the rap album situation is that

08:13

the numbers are extreme in their variability like you either

08:17

Spend your life doing open mic nights or you open

08:21

for m and m Yeah them so far ends of

08:23

the spectrum Enormous deviation or standard deviation among outcomes Yes

08:28

we're reviewing from your stats course here people But we

08:31

need thio further review here's set of Numbers a 15:14 18

08:35

bhola blossom Numbers b 0:3 58 one twelve alright guess what

08:39

a is and guess what he is waiting waiting okay

08:44

a is what a portfolio of seven publicly traded stocks

08:49

did in a bullish market over the course of two

08:51

years and v is what a venture capital portfolio did

08:55

over the same time period note how much more variable

09:00

the venture investments were a bunch of them went fully

09:02

bankrupt that's what zeroes mean and in one you'd have

09:06

made a one hundred twenty five times your money in

09:08

two years yeah nice work if you can get it

09:11

well the public set of stocks was relatively low beta

09:14

and the private investments were very high beta mathematically most

09:20

investors think about beta as performance relative to the market

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and when they say market it's a fair question to

09:27

ask which market and when we say market around here

09:30

we think of the standard as being the s and

09:32

p five hundred But if you're talking about tech stocks

09:35

while most people think about nasdaq as the market okay

09:38

how about a super simple example definition of beta here

09:41

Well yes and p five hundreds of twenty thousand It

09:44

goes up ten percent in a year and it ends

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up twenty two thousand Your ten dollars stock in boring

09:49

co a drilling company not an emotional delimiting company ends

09:53

its urine eleven dollars it's beta relative to the s

09:56

and p five hundred is one meaning for each unit

10:00

that the market moved up Your sir stock moved up

10:03

the same amount But you have another stock in your

10:06

portfolio called snort mongers a chain of comedy clubs that

10:10

serves super foamy root beer So when audiences laugh it

10:14

shoots out of their nurses Uh well the public fell

10:17

in love with this chain and its stock went from

10:19

forty bucks a share Two fifty two bucks went up

10:21

thirty percent beta three Well it moved three times as

10:24

much as did the market in that year So don't

10:27

listen A weight lifters jocks or bro's about how important

10:30

It is to be alfa The real winners here know

10:33

that beta is where you reach the cash and think

10:36

really hard before you invest in that rap album from

10:40

your crazy uncle larry he's Not really a cz good 00:10:42.977 --> [endTime] as he thinks he is

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