Now, we're talking about the security market line, the basic, the most impressive conclusion of the capital asset pricing model in finance. It is a relationship between the expected return on an asset and its beta. So, what the equation says is that the expected return on the i asset is equal to the risk free rate expected. Actually, it's the same as the expected because it's known with certainty plus the beta of the i asset times the return, expected return on the market minus the risk free rate. So, that is the most famous equation. What it says is that this is a consequence of two things. The theory of forming an optimal portfolio, which we have already discussed, also, the assumption that everybody does it. Okay, now, that second assumption has always bothered me. But, let's go with it for now. We're talking about a world in which everyone has a smart money manager who looks at variances in covariances and figures out. Then in that world, it should be that this equation holds, some assets have a higher return than other assets. Does that mean that investors were stupid who invested in the other assets? Absolutely not. The higher return is associated with higher beta which means more risk. And, I've just, we've just derived what the smart investor would do. And, the smart investor would hold all of the stocks. All of the assets, whether, it's stocks, bonds and real estate, everything gets held and not everything has the same predicted return. You can predict that some will earn more than others but it's always because of higher beta. So, let's think about this. Some assets have a expected return which is less than the riskless rate. Those are negative data assets, like gold. And so, we say, why would anyone be so stupid as to invest in gold when it has a lower return than the riskless rate? And the answer is, it's not stupid at all. The negative beta is helping reduce the overall variance of their portfolio. Because gold goes up when the stock market goes down, it offsets other risk. And there are other assets like Apple Computer. We can look back and say wow it had a really high return over the last 20 years. Was I a fool not to put all my money in Apple? No, you weren't a fool. You did exactly the right thing because, you didn't know the risk, how the risk outcome would come. You may know that it has a high expected return. But, Apple is, if you trust the beta, it has a high beta, it's plunging, it's a risk, it's a stock that won't help you in the stock market crash. Right. And offsetting that, it will really help you a lot in a boom. So, this is a description of a world in which everybody is holding the tangency portfolio. We are not enticed by Apple. We're not scared off by low return assets. But, it all fits a model of looking at beta and adjusting your portfolio so that you have the optimal mix. It's kind of a complicated theory because it involves this tangency portfolio, it involves thinking about leverage, it involves thinking about how things move together. But, it is really the core idea in modern finance. That doesn't mean to say that it's absolutely right. It's not absolutely right. It's only a half truth. The problem is that not everybody is holding the optimal portfolio. We don't all own the same portfolio of risky assets. The world isn't quite consistent with this. But, I think it is a very useful exercise to think about an idealized world where this holds. Is it fair to think of a stock that has a negative beta as being like an insurance, playing an insurance kind of role in your portfolio? Absolutely. A negative beta stock moves opposite other risk. So, you may own Apple computer as an element of your portfolio. But you know, it doesn't have to work out well. Even though ex ante, the Apple computer was run by brilliant people. History shows, that there is risk in that. And so, you want to have it in your portfolio but you want other things in there as well. And, what you really like, are things like an insurance policy against failure of Apple Computer. Now, you can call that an insurance contract. You could also call it a credit default swap, which is you could focus that on a particular company. But, yes. The the concept of insurance is fundamental to the concept of finance. I don't know why they separate them out. They're really two different aspects of the same thing. So, early on we were talking about gold as being an example, I mean a more modern example, is like when you mentioned the credit default swap. That's like a contract that is designed to pay out when the market is low. So, it's like customized beta. Insurance is a different industry, it has different historical origins and it's regulated differently. So, securities in the United States are regulated by the Securities and Exchange Commission. However, insurance is not regulated by the federal government. It's regulated by the state governments. And so, it's different people but, they're doing similar things. So, really here then I can use this concept to think not only use about stocks and bonds but really derivatives or any kind of asset class potential. Or you can think about, yeah, people make finance analogies to life's decision. So, we're going to come up later about options. But, an option is something you pay for the option to choose later. Some people have said that, "committing yourself to marry someone is like exercising an option." So, people who are hesitant to commit are just people who have the optimal exercise strategy for their marriage option in mind. That's a joke. But, it's not entirely joking. The issues that finance covers are issues that are business analogs of fundamental risks in our lives. And so, you can draw further insights from all this. Then also, I didn't mean to speak so flippantly about marriage. I've been married for 40 years. I don't think fervently about it at all. But, there is some people who make analogies between business and marriage and other things. And the analogies are not entirely off the mark.
