Diversification in Investing: Response to Meet Kevin, Kevin O'Leary, Graham Stephan.

hello and welcome back to patrick boyle on finance last week in the comments section of my risk parody video a viewer named vladimir zarik asked my opinion on whether diversification actually makes sense for young investors vladimir linked to a video which was a reaction video by meet kevin to a reaction video by kevin o'leary to a video by graham stefan so i guess this video is a reaction to a reaction to a reaction of a video which you know as you can imagine it's getting a little bit worrying at this point and this could possibly continue on forever on youtube hopefully eventually graham stefan might be able to put an end to this but anyhow in the reaction to the reaction to a video meet kevin said that he disagreed with kevin o'leary's argument that diversification is of great importance when investing meet kevin in his video argues that this might make sense for older people but makes no sense for young people who should be taking more risk well unfortunately i do have to disagree with meet kevin who disagrees with kevin o'leary who disagrees with graham stefan and hopefully that makes sense to everyone watching this meet kevin said this in his video and it depends on which phase of life you're in let me try to explain that sometimes i hear people say kevin i've got ten thousand dollars saved up and i'm so diversified when you're early in life and your net worth is ten thousand dollars i would take a completely different approach than what kevin o'leary is recommending i would rather see taking that ten thousand dollars and purposefully doing what graham did and concentrating it into real estate whatever amount of money it is when you first start out with a very low net worth you're in what i call the building fork of life your goal in my opinion is get off the ground floor concentrate your investments into where you know you can make a lot of money build wealth then once you reach a certain net worth whether that's two hundred thousand dollars five hundred thousand dollars or a million dollars or whatever number that you feel comfortable with then it makes sense to start protecting the base but when you have zero dollars it doesn't make sense to try to protect the base because you don't really have anything to protect in order to understand how diversification works we unfortunately do have to look at a few ideas from the world of statistics we have to look at things like expected return on investment standard deviation and correlation we're not going to do much math here i'm just going to try and explain these ideas in an intuitive manner but if you're really interested all of these ideas are explained in my textbook statistics for the trading floor and i'll link to that in the description of the video below anyhow let's just start with expected return so expected return is quite simply the return an investor expects to reap based upon their investment in the same way that a farmer plants seeds in a field to grow a crop an investor puts their money into investments that they expect to grow in value the farmer will have an expectation as to how well his crop might grow and an investor will equally have an expectation as to how well their investments will perform they might base this on the historical returns for that asset class they might base it on various measures of cheapness of a given asset which they expect to return to fair value over time or they might even have built detailed valuation models for all of the assets that they are considering investing in there are numerous ways that this can be analyzed but usually an investor will only invest in a riskier asset with the expectation of a higher return if an investor invests in a portfolio of assets their expected return is quite simply just the weighted average of the expected returns of all of the individual assets so that's not really a complicated formula now the next statistic we need to talk about is standard deviation and standard deviation is a statistical measure of dispersion or variability if the expected return is the return that we expect to get on a given investment the standard deviation tells us a little bit about our confidence it tells us how variable that return is likely to be the standard deviation will tell us to what extent the outcomes of an investment can be expected to differ from our expected return when we predict an expected return and the standard deviation we're essentially predicting a bell curve of future likely returns the higher the standard deviation is the wider our bell curve is and thus the more variable the possible outcomes are likely to be as an example if you put your savings into a fixed rate government guaranteed savings bond the expected return is quite simply the return on the bond and the standard deviation will be extremely low simply because it's very unlikely that you'll get any more or less than this expected return so that's a really low risk security as you invest in riskier products like we'll say corporate bonds real estate stocks or commodities the range of possible outcomes gets wider and thus the standard deviation is greater so that means you might do way better or way worse than you expect you'll only accept this greater level of variability in the returns for a higher expected return and so for this reason we use standard deviation as a measure of risk in finance if you want to learn more about standard deviation as a measure of risk i'll link to a really good video in the description below by the plain bagel that came up about a week ago now the final and possibly most important statistic that we need to understand to understand diversification is correlation now correlation is a statistical measure that indicates the extent to which two or more variables fluctuate together a positive correlation indicates the extent to which the two variables increase or decrease in parallel a negative correlation indicates the extent to which one variable increases as the other decreases and vice versa if two variables are uncorrelated then there's no linear relationship between them correlation ranges between one for things that move in lock step with each other to minus one for things that move precisely opposite to each other a correlation of zero indicates that the returns have no relationship to each other and so correlation will be somewhere in that range in order to understand how these three statistics work together for investors let's take a quick look at an example of a two-stock portfolio so it's a very simplified approach we're going to have two stocks abc and xyz in the example abc is an expected return of 11 and xyz has an expected return of 25 abc is a standard deviation of 15 and xyz has a standard deviation of 20 so as you can see xyz is riskier with a higher standard deviation and it also has a higher expected return the correlation between these two assets is 0.3 this is a positive correlation so it means that in general they might move up and down together at the same time but it's a very weak correlation meaning that there is an awful lot of randomness in this relationship so they're not that tied to each other we've then put together six different weightings of a portfolio of this pair of stocks where you can have either all of your money in one stock or all of your money in the other or varying weights in either of the two stocks the expected return of these six portfolios is very easy to calculate it's just the portfolio weight times the expected return of each stock and then we just add them up the expected return is shown on your screen in the row labeled e or for expected return now the way we average standard deviation however is more complicated than than averaging the expected return and i'll put the formula up on your screen right now and this formula takes correlation into account and we do need to take correlation into account when we're averaging these standard deviations because obviously if they move together we're going to have more volatility than if they're really random and moving opposite to each other or if they're if they have a negative correlation and so as you can see in the table for each portfolio there's a different expected return and risk as measured by standard deviation now the interesting thing though is that we have two portfolios there that are showing the same standard deviation or risk if you have 80 percent abc and 20 xyz that is the same standard deviation as 60 abc and 40 xyz now that might at first seem uninteresting but the second portfolio is a higher expected return of 16.6 compared to 13.8 percent for the same level of risk now you'd obviously prefer to have the higher returning portfolio for the same amount of risk any investor would so what this tells us is that there are better and worse ways of waiting a portfolio it also shows us that it's possible to reduce the risk of a portfolio through diversification without reducing the expected return and that's what diversification does for you it reduces the risk or the volatility without reducing the expected return does it make sense for all investors no matter what their age is simply because a rational investor would always want the highest return available for a given level of risk and that's what diversification gives us you might at this point say that while this appears to all make mathematical sense i'd still rather invest all of my savings in xyz as that's where i get the highest return that 25 return but that's not your only option if you wanted a return of 25 you'd be better off leveraging a diversified portfolio until you reach that level of expected return instead of putting all of your money into one stock as an investor it makes sense to always think of risk in return as being tied together as being the same thing rather than separate unrelated entities the idea behind diversification is that by investing in a basket of different assets that are affected differently by different economic inputs you can reduce the risk or variability of your overall portfolio the reason for this is that if these assets all have a positive expected return but are anything other than perfectly correlated to each other when one is moving up another might be moving down or sideways or just doing something else while they're all generally drifting in the direction of their expected return you're getting this dampening effect of them moving differently to each other within the portfolio we'll say for example if you're an auto insurance company you would diversify by writing insurance policies on thousands of different cars some will crash and make claims on the policies but most won't and diversification does works for you it means that you're not exposed to the specific risk of one driver in one car when you diversify you should end up having the same expected return as someone who wrote just one insurance policy but it's considerably less likely that you will lose everything as hopefully a thousand the 1000 randomly chosen cars that you pick to ensure shouldn't all crash within a given year now as an investor you invest in a basket of different stocks and even if one or two do badly overall you should in the long run get the return of the stock market i think that what meet kevin was probably trying to say in this video is that young investors should consider taking greater risk than older investors who've made their money already and are closer to retirement now this does make sense to me let me know your thoughts in the comment section as to how you think age should affect your investment decisions most investment advisors would argue that the longer your investment horizon is the greater the risk you're reasonably able to take when you're young you have plenty of time to make back any losses that you might make and the best way to take this additional risk though is through a more aggressive asset allocation rather than by putting all of your eggs in one basket different assets have different risk and return profiles bonds have a much lower expected return and risk than real estate which is a lower expected return in risk than stocks a young person might want to invest more in a diversified basket of stocks than in a diversified basket of these other lower yielding assets investment advisors will tell you that your decision about how much to allocate to stocks versus bonds will have a much greater effect on your long-term returns than the specific securities that you pick now in order to diversify you might ask how many stocks should a person buy well this question was answered in 1977 by elton and gruber who did an empirical study on the benefits of diversification they looked at combinations of over 3 000 stocks i think it was like 3 200 or something like that for possible inclusion in a portfolio the results are shown on the table on screen right now as you can see a four stock portfolio is considerably less risky than a single stock and the results for 20 stocks provides most of the reduction in risk that you get from going to a thousand stocks it makes sense for an investor to invest in a variety of different industries and investing in international stocks also will add an awful lot of diversification to a portfolio basically the idea is that you would benefit more by finding investments that are not as correlated to each other diversification is one of the few tools available to investors that will improve their risk return trade-off so you should obviously make the most of it if you found this video helpful don't forget to hit the like button and subscribe and hit the bell icon in order to see more videos like this oh and one more thing the winner of the book giveaway that i mentioned in the last video is kyle larson so i'll be mailing out a copy to kyle as soon as i get his mailing address see you guys later bye [Music] you

Channel: Patrick Boyle

Views: 37,338

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Keywords: finance, trading, patrick boyle, on finance, cfa exam, level 1, level 2, level 3, kings college london, business school, queen mary university of london, quantitative finance, financial derivatives, diversification, statistics, financial mathematics, meet kevin, kevin o'leary, graham stephan, reaction video, how does diversification work, should young people diversify their investments, should young people take more risk, should you diversify, how to diversify

Id: gXWYpVjMVsA

Length: 15min 42sec (942 seconds)

Published: Thu Oct 15 2020