23Financial Theory

23Financial Theory - Financial Theory

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Financial Theory: Lecture 23 Transcript November 19, 2009 << back Professor John Geanakoplos: Okay, I think I should begin. So we're at the point in the course now where we're talking about the Capital Asset Pricing Model and the economists’ understanding of risk aversion and its consequence for the financial sector. So much of what economists know was already known to businessmen, because it's common sense, and even to literary writers like Shakespeare, who was himself quite a successful businessman. So you might remember that Shakespeare already had the idea of diversification. In the Merchant of Venice, Antonio says "Each boat on a different ocean." He said it a bit more poetically than that, "each sail on a different argosy" or something. I've forgotten what it was, but each boat on a different ocean. So he wasn't very worried because he was diversified. He also had the idea of risk and return. Nothing ventured, nothing gained. Nothing ventured, so ventured means risk. Nothing gained. So another way of saying this diversification is "Don't put all your eggs in one basket." So what have economists done that wasn't already known to every business person and every clever literary writer? Well, economists have quantified this and turned this into a usable, practical piece of advice. So the diversification theorem in CAPM-- so I should have moved CAPM. I should have called this Shakespeare and this CAPM. CAPM becomes the mutual fund theorem. So the mutual fund theorem has very practical advice. It says if you're investing in the stock market, don't try to pick out individual stocks. Hold every stock in proportion to its value in the whole economy. If you want to be more venturesome, don't pick riskier stocks. Just simply leave less money in the bank. So divide all your money between the index and the bank. It says, hold all your money in stocks in the same proportion everyone else is holding them. Hold the market, in other words. Hold an index like the S&P 500, of all the stocks, in proportion to how big they are. And if you want to get more venturesome--if you're cautious, put some of your money in the index and some of it in the bank. If you want to be more venturesome, take some money out of the bank and put it into the stocks. But in the index. If you want to be even more venturesome than that, borrow the money to put the money into the stock market. That's called leverage. But you should, according to this theory, not try to pick stocks. So if you're interested in risk, you shouldn't pick high technology startup companies. You should pick the same mixture of blue chip companies like General Electric and these startup companies that everybody else is choosing. So that's what it means to diversify. Hold a little bit of everything in the same proportion as everyone else. So it's much more precise, much more surprising than Shakespeare's advice.
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This note was uploaded on 02/08/2012 for the course ECON 251 taught by Professor Geanakoplos,john during the Fall '09 term at Yale.

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23Financial Theory - Financial Theory

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