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Fundamentals of Personal Investing

Fundamentals of Personal Investing
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So hopefully you've had the time to think about the 10 companies and the S&P 500. So what's going on? The first thing that jumps out at you, hopefully, is that all the stocks have high standard deviations. Then there is S&P 500. And this probability of this happening is very, very high. In fact, the lowest run next to it is 16%. So one of the things that's pretty amazing is, and this is one of the fundamentals of diversification, is if you took the average standard deviation of the ten stocks, if you just average them, and I'm eyeballing them, I didn't average, because I just wanted you to have fun.
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Chances are, they're about 30% or at least greater than 25% as the average. Just stare at it. The highest is 40, the lowest is 16, and they're hovering between those numbers. So turns out substantially greater volatility, on average, for individual stocks, as opposed to S&P 500. And they're representative of many industries. They're not all in tech or something like that. [COUGH] So what this tells you is, the notion of a portfolio makes so much sense, because what happens is as soon as you combine stocks in a portfolio, standard deviation starts going down, volatility starts going down. And the reason is very simply. There are two kinds of risk.
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Broadly speaking in each stock, and one is called, some risk that changes with the whole world, the whole economy, the global economy. So if the economy goes up the stock goes up. If the economy goes down, the stock goes down. So one source of risk is market risk, the other source or risk is the stock has something specific to it. It's called idiosyncratic. Long word, or specific, or peculiar to company. Could that happen? Sure, the company's stock may be jumping up and down regardless of what's happening to them. Marketplace. That's called specific risk. So what happens when you combine a bunch of stocks together? Which of these two risks actually cancels each other out?
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And if you have done a little bit of math, or statistics, or use your intuition, it becomes obvious that it's the specific risk that cancelled because it's not related to each other. The market is related. So the reason why, say, IBM's price goes up related to the market is the market is common to IBM but it's also common to Xerox or it's also common to Intel. So that risk stays, but the risk that's peculiar to the three of them tends to cancel. And you can show very quickly, you can show that if you select stocks across the entire spectrum possible, like the S&P 500, it'll pretty much get rid of idiosyncratic risk. And that's what's going on.
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That's why people love portfolios, because that's the same as not putting all your eggs in one basket. So what are the bottom lines of investing? You know bonds, you know stocks, you know what I just said. Even without doing risk in detail, if we are risk averse and seek to minimize risk, we should hold portfolios, not stocks. That's that simple. I just showed you that. Why take on volatility that's unnecessary? If markets work, we may want to just hold portfolios. What I mean by that is existing portfolios. So if markets are working and you have an existing portfolio stocks called S&P 500. You now can just hold that portfolio, the whole portfolio by itself. It's pre-constructed.
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You're not buying into new stocks. So what's happening? You're holding portfolios are not only diversifying, you're not picking in the jewel stocks to put in your portfolio. So a preexisting portfolios are mutual funds have become unbelievably popular. In fact, and the main reason is the reduce transaction cost. So why would you create your own portfolio and spend money? Because every time you buy and sell a stock, there's 1% that makes money. And that percent is the broker. So why don't you buy and hold? That is the reason why mutual funds have taken off. Mutual funds are existing stocks in the portfolio. Now, of course, there are many such portfolios available. So why?
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Because even the risk of each one of them is different. So for example, if I want a more risky portfolio, I could just create it and it's just so cool. I can buy the market, invest in the S&P 500, and borrow and invest in S&P 500. And automatically increase my risk. Why would I do that? I'll do that only because I won't like more risk because I like more return. So if I'm risk averse, doesn't mean all of us have the same level of risk tolerance. But all of us would want a reward on average for taking on risk.
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So I want to pause here and say one last thing about risk and return, is that you are much more in control of your investment strategy. So figure out what your tolerance will risk is. So suppose you are a person who's only investing in government bonds as supposed to stocks, nothing wrong with it. Risk and return come in pairs. You're neither a good person nor a bad person for it. You just have a lower tolerance for risk. On the other hand, the more and more you go towards stock, you're revealing your preference for risk.
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And these days, you can buy portfolios with an array of different risk profiles and they'll come with, on average, an array of different returns which match high risk, high return. This is such a simple 101 of finance that it's unbelievable how few people actually practice it. There are many people who think they can beat the market, but there are others who are so uninformed that they think that somehow creating a portfolio requires some kind of a genius. No, it doesn't. In fact, a lot of portfolios are available currently that are very low transaction costs, and basically they make the whole market.
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The different mixes of risk of course, therefore there are many, now you can also be diversified within an industry if you want to take that chance, and then you have industry portfolios and so on.
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We'll take a little break. I'm going to now move on to the next clip and talk about what's next in the course and what after the course. So this is true wrap up time, so that you get a sense of where you could head. And where I would love you to head if you were to choose to go in that direction of course.
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