Financial Markets: Lecture 4 Transcript
January 28, 2008
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Professor Robert Shiller:
Today's lecture is about portfolio diversification and about supporting financial
institutions, notably mutual funds. It's actually kind of a crusade of mine--I believe that the world needs more
portfolio diversification. That might sound to you a little bit odd, but I think it's absolutely true that the same
kind of cause that Emmett Thompson goes through, which is to help the poor people of the world, can be
advanced through portfolio diversification--I seriously mean that. There are a lot of human hardships that can
be solved by diversifying portfolios. What I'm going to talk about today applies not just to comfortable
wealthy people, but it applies to everyone. It's really about risk. When there's a bad outcome for anyone,
that's the outcome of some random draw. When people get into real trouble in their lives, it's because of a
sequence of bad events that push them into unfortunate positions and, very often, financial risk management
is part of the thing that prevents that from happening.
The first--let me go--I want to start this lecture with some mathematics. It's a continuation of the second
lecture, where I talked about the principle of dispersal of risk. I want now to carry that forward into
something a little bit more focused on the portfolio problem. I'm going to start this lecture with a discussion
of how one constructs a portfolio and what are the mathematics of it. That will lead us into the capital asset
pricing model, which is the cornerstone of a lot of thinking in finance. I'm going to go through this rather
quickly because there are other courses at Yale that will cover this more thoroughly, notably, John
Geanakoplos's Econ 251. I think we can get the basic points here.
Let's start with the basic idea. I want to just say it in the simplest possible terms. What is it that--First of all, a
portfolio, let's define that. A portfolio is the collection of assets that you have--financial assets, tangible
assets--it's your wealth. The first and fundamental principle is: you care only about the total portfolio. You
don't want to be someone like the fisherman who boasts about one big fish that he caught because it's not--
we're talking about livelihoods. It's all the fish that you caught, so there's nothing to be proud of if you had
one big success. That's the first very basic principle. Do you agree with me on that? So, when we say
portfolio management, we mean managing everything that gives you economic benefit.
Now, underlying our theory is the idea that we measure the outcome of your investment in your portfolio by
the mean of the return on the portfolio and the variance of the return on the portfolio. The return, of course,
in any given time period is the percentage increase in the portfolio; or, it could be a negative number, it could
be a decrease. The principle is that you want the expected value of the return to be as high as possible given