The capital asset pricing model. It's a model of the optimal portfolio. It asserts that all investors will hold the optimal portfolio. So anyway, I showed you last time a scatter diagram which had on the horizontal axis, the return on the stock market and on the vertical axis, the return on Apple Computer. And there was a scatter of points, one for each year, the return on the market and the return on Apple for that year. And I have fitted a line to that scatter points. The slope of the line is called beta. The idea here is that individuals should diversify. They should hold all the many different eggs in their basket. But diversification is difficult for individual investors. Partly because if you're a small investor, you'd have to buy fractional shares of each company and you know, the stockbrokers prefer that you do what's called round lots of 100 shares. So, you just can't do it, you're too small to diversify. So you need some company to help you diversify your portfolio. So, the idea has been going back many decades, that people need investment funds to manage their portfolio for them and the investment funds can diversify optimally for them. So before the 1940s, we had what were called investment trusts. Later they became a different form called the mutual fund. The first mutual fund is Massachusetts investment trust, MIT, not the institute, in the 1920s but they didn't really take off until after the 1940s. So a mutual fund or management company, invests in your behalf in assets and it's mutual in that, it doesn't skim off profits to a class of stockholders, it's divided up equally among all the people who invest in the mutual fund. But the mutual fund puts together assets, hopefully, in a diversified manner. So, I know the question of whether we're really talking about complete diversification or not. Often when we talk about the Capital Asset Pricing Model, or I should say usually, it is assumed that we're diversifying across all stocks. And maybe all stocks and all bonds. But in fact, if you wanted to be completely diversified, you'd want to include other assets like real estate or commodities like oil, as well. I put this up because I- I had to take a exam to get licensed as a stockbroker at one point in my career till I had a company and it turned out I had to be licensed so I took the exam to become a stockbroker. I never was a stock broker in my life. And the exam study materials is a series seven exam that some of you might end up taking if you go into finance. They talked about classifying all the different investments that someone might make in terms of risk. So, there is low risk, moderate risk, moderate risk, high risk and speculative. Now they have a range of mountain climbers climbing to the top. Now they didn't say what- I had to memorize this for the exam. Something didn't- bothered me about it though, they didn't say what you do with this picture of a pyramid. So, it sounds like looking at the picture, like we are supposed to be climbing up to the most speculative investments. I don't know. But what I thought is, there's nothing wrong with this diagram, but somehow it's misleading. What, what CAPM says, doesn't matter what your risk is, you want to hold all of these. It will average out to be the best for you. So speculative; art, gems, precious metals, options, commodities venture, capital. I want all of them. Okay. Do you want these too? Yes, I want all of them. It's very simple. It's not like going to a candy store, you probably just buy one piece of candy. You walk into the candy store and say, "Give me one of everything." That's what you should do. Now, if you look historically at different asset classes, you find historically they have paid different amounts out on average through time. Jeremy Siegel was an old friend of mine at the Wharton School, has just come out with the fifth edition of his book 'Stocks for the long run'. And he calculates the average return on the stock market in the United States from 1802 to 2012. That's 210 years of data. It's a lot of data. And he finds that correcting for inflation. The real inflation corrected return on average for those 200 years was 6.6 % a year. On the other hand, the U.S., the geometric average real short term government return was only 2.7%. So that the equity premium- equity means stocks. The premium of stocks over short term saving vehicles on average for 200 years, was 3.9%. So then, he poses it as a puzzle at the beginning of his book. How can that be? That's- 200 years is a long time. I'm thinking, everyone this year first thought, should invest in the stock market. Why does anyone invest in short term governments? So this is called the equity premium puzzle. How can it be that one investment has done so much better overall for 200 years compared to another? And that's what we're going to try to understand with the capital asset pricing model here. It's not just for the U.S. but not as dramatically. Will Goetzmann said that to some extent, the U.S. equity premium is a problem of reflex, a selection bias problem. The United States is the most successful capitalist country in the world, you might argue. I mean, someone might try to argue otherwise, but if we're not we're pretty close to it. So, you're looking at the success of stock market investments in the United States is misleading. So you might say, "let's look at another country, how about Russia?" All right. Well, let's think, whatever happened in Russia for taking a long from 1802. You know, I kind of remember there was something called the Bolshevik revolution. So basically, it was wiped out. You didn't get anything. So, they're not uniformly a good example but at least in the U.S, it seems like now, we may be making a fallacy in assuming that this will is God's law that stocks outperform other investments but it seems like there have been. So, do you think that using historic data as a standard deviation or expected return is really helpful in understanding what's going to happen in the future? Alright. You're getting at a basic issue is what do we know about the future? And does the past have any indication of the future? Big question. So, let me give you an example; Utilities stocks, that's electric companies, gas companies. They, they've... every month they, they've keep the lights on. They've been doing this for a long time. So they're boring stocks and they'd hardly ever have gone bankrupt. So people think those are safe stocks with a low beta or low idiosyncratic variance, and maybe they don't pay the highest return. Now, and so that would be... that would be supported by data for the last 50 years that they've been boring investment. So it almost seems reasonable doesn't it? That they're going to continue-what's exciting about them? You know? But on the other hand, if you look at the history of- I'm just bringing up utilities, they weren't always boring. Particularly the 1920s, when the world was becoming electrified and electricity was new and these lights were exciting. You've switched- in fact that this is an old room, I think you can still see the gaslights. I don't see them, they remove them. This was obviously lit by gas when it was built, not by electricity. Once the- the electricity is so much brighter and impressive so people were excited about it. So in 1929, that sector that grew the most and crashed was the utilities sector. So, that means you can't necessarily trust past behavior of stock prices as an indicator of the future. I think that it's kind of halfway, you can sort of trust it if you know a reason to think otherwise, then you wouldn't. When you get to other things like Facebook or Google, or whatever, or alphabet, what do you think about their future return? Is that predicted by their past return? Now, who knows? It's changing, everything is changing too fast.