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transcript05 - Financial Markets: Lecture 5 Transcript...

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Financial Markets: Lecture 5 Transcript January 13, 2008 << back Professor Robert Shiller: I wanted to talk today about insurance, which is another risk management device that's traditionally separate from securities, which we talked about last time, but the underlying principles are the same. Before I begin, I want to just give some more thoughts about the diversification through securities and that will lead us into insurance. Let me just review the preceding lecture briefly for that purpose. What we did--the core theoretical framework that we had--was the mean variance theory, which led us to the capital asset pricing model. But the basic thing was that we had to--in order to use the framework--we had to start by producing estimates of the expected returns on each asset, we called those r , and the standard deviation of the return on each asset and the covariance between the returns of each pair of assets. Then, once we did that we could plug that into the formula that I gave you last time and get the standard deviation of the portfolio and the expected return on the portfolio. From then on, if you accept the analysis and the assumptions or the estimates that underlie it, then we pretty much know how to construct portfolios. The underlying estimates may not accord with your belief or your intuitive sense of common sense. The other thing that I mentioned last time was that there seems to be a really big difference between the expected return on the stock market and the expected return on short-term debt. We found an equity premium--or actually Jeremy Siegel's book gave an equity premium of 4% a year. Some people find that hard to believe. How can it be that one asset does 4% a year better than another? Some people say, well if that's the case I want to invest in nothing more than that one asset. Why should I take something that is underperforming? Jeremy Siegel goes on further to say that since the mid-nineteenth century we've never had a thirty-year period when stocks under performed bonds, so stocks are really--if anyone who has an investment horizon of thirty years--you'd think, why should I ever holds bonds. The numbers that Jeremy Siegel produces seem implausibly high for the stock market. What we call this is the--I want to emphasize it, I'll write this again--the equity premium puzzle. That term was actually coined by economists, Prescott and Mehra; it's now in general use. That is, it just seems that stocks so much outperform other investments. For Jeremy Siegel, in the latest edition of his book, the equity premium is 4% a year since 1802. That's almost--no that's more than 100--that's 206 years. Why would that be and can you believe that? One question that comes up is that maybe--this is for the U.S. data--and some people say, well, maybe, why are we looking at the U.S.? Because the U.S. is an arguably very successful country, so we have, potentially, a bias in--it's called a selection bias. If you pick as the country you study one of the most successful countries in the world,
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transcript05 - Financial Markets: Lecture 5 Transcript...

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