The idea of covariance.

When you have two separate stocks,

for example. >> Okay. [COUGH] I'll try to start
keeping things really simple. There's two different companies. They're both
startups and they're
both trying some risky new venture. And they both,
it's like a coin toss, right? They both have a 50,
50 chance of succeeding. And if they succeed they're
worth a million dollars, and if they fail they're worth zero dollars. So we have
two probability distributions, one for the stock one, right? This is one million
and
this is zero and this is 0.5. I'll leave it at 50, 50 for now. And this is stock
two, 0, 1, 0.5. So it looks the same. [COUGH] Now the question is, are these
two businesses really independent? We've shown their
probability of succeeding. But if I'm going to invest
in both of them as a smart venture capital firm might do,
what do I make of that? Are they the same or different? So let's say the mean is
0.5 for
both of them. It's like a fair coin toss, all right? And so, they will deviate
either plus 0.5 for the mean, or minus 0.5 for the mean, both of them. Now but the
question I want to
know as an investor, are they going to do the same, or
are they independent of each other? There's four possibilities,
the covariance, C-O-V, covariance between the two returns is probability rate
average of,
so now it gets to variance. But it's between two companies. So let's consider,
what's the first possibility? They both succeed. So it has a 0.25, one and four
chance of being a half
above the mean for both of them. So that's 0.5 times 0.5, right? And then it has a
25%
chance of both being 0. So it's 0.25 times -0.5 times -0.5. But then there's the
chance that one of
them succeeds and the other one doesn't. That has a probability of 0.5, because
there's two different ways it can go. >> Right.
>> It could be A, that succeeds and B, fails or otherwise. So we have 0.5
probability of -0.5 times 0.5. So what does that add up to? It adds up to 0 right?
Because these are both positive numbers,
but these are 1. So the product -0.5 times -0.5 is plus. And so, this is equal to
a half times a quarter, right? The two terms here. >> Right.
>> And that's the same here, but with a minus sign, so it cancels out. So if
they're really independent
like that then the covariance is 0. >> Okay. >> And we like that as investors,
we don't want to get in trouble. So we want to see
an independent investment. But on the other hand it could be that
the two companies are really the same, they really betting on the same idea. And
so, these are not possible, all right? This probability goes from 0.5 to 0. And
then this probability goes to 0.5, and this probability goes to 0.5. >> I see. >>
So now we have a covariance of 0.25. It's not 0 anymore, and that's a flag that
there's danger here. And the other possibility is that
they're exact opposite of each other. Only one of the two will succeed,
one will succeed and the other fails. And that would be a negative covariance. So
these things matter, and they become central to our theory
in the capital asset pricing model. This is something that is not in the habit
of thinking of most amateur investors. They look at their investments
one at a time, and they don't, you always have to go back and
say, what's the covariance? That's what really matters for
what happen to your portfolio. Because when you invest in a lot of
companies that are all the same, you're asking for trouble, because the
whole thing is going to either blow up or succeed. And you can't live like that.
You have to be looking for low covariance. The theory of capital S
pricing theory tells you how to take a count of covariance. >> Okay, so then really
this
covariance kind of changes based on how we assign the probability
of each pair of outcomes occurring. So what's the probability
of them both succeeding? Here we put 0.5. And what's the probability of them both,
which is like 0 and 0, so that would be 0.5. And we gave no probability to the case
where one succeeds and one fails. So that kind of, is the fact that
the covariance is positive is kind of indicating that these
two stocks tend to do this. They move in the same direction. >> Right.
>> But they're kind of simultaneously moving in the same direction. >> So this is
the basic bottom lesson. Risk is determined by covariance. >> Right.
>> Especially if you hold a large number of assets. Idiosyncratic risk just doesn't
matter. It all averages out. It's this kind of thing where they do the
same thing that you have to worry about. And this is a basic lesson in finance. It
just doesn't come naturally to
most people, you have to ponder this. >> So that's really interesting, because
when we come to finance most people think of that risk is just
the variance possibly. But actually we're saying it's
actually more granular than that. It's actually the covariance of a stock
with, let's say the broader market. >> Well yeah, because any investor has
the option of investing in everything. >> Right.
>> Because there are mutual funds hat will do, there are world funds that put
their money all over the world And so, why shouldn't you do that? It sounds like
it's a pretty
good thing to do actually. But the one thing they can't get rid of
is the market risk for the whole world. That's there,
because if you hold the whole world, you're still subject to the world's risk. But
that's what an investor
needs to be focused on, and this is a bad habit among
many individual investors. They just look at one stock and
they think, I'm going to put all my money in that. >> Right. >> And they just don't
consider
how many different options for risk spreading they have in this
vast world that we have around us. >> Okay, and this idea seems very
quite similar to when we were talking before about the market
return versus Apple and we had-
>> It is. >> So then we had different betas, and
so that's kind of getting at covariance- >> In fact the beta of the i stock is its
covariance-
>> Okay. >> With the market. Divided by the variance of
the return on the market. It's just a scaled covariance. >> Okay? >> And the
average beta has to be one, because I could substitute
the average return on the assets. And that's the return of the market, so then the
covariance of anything with
itself is equal to the variance. It just equals one. >> Okay.
So then, if you're more than that versus less than,
I see, okay. >> So you want to be careful. In other words, the basic says, that the
market demands higher
returns from higher beta stock. That means high covariance
with the market stock. And they're willing to take no
returns if the beta is low, because that means it's less
contributing to risk in the portfolio. >> Okay. >> In fact, if you can find a
negative
betta stock, or lets say goals, it may not always be negative data. But lets say in
theory
it is negative beta. Putting gold into your portfolio,
it has no return at all. It doesn't pay dividends, nothing. >> Right.
>> But it moves opposite your other investments. That's the theory. >> Okay, and
everything we're talking about here, we have this presumption
that we're all risk averse. And so, I just want to state that's a key part to why
we
care about covariance. >> Yeah. >> But
if there's somebody like George Soros or Warren Buffett,
maybe they're less risk averse. >> I have no fundamental insights into
either George Soros or Warren Buffett. My guess is though,
that they have this theory firmly in mind, and they may want to take risks at
times. See, the real world is not so
cut and dried as I showed here, but we know the probability of everything. So they
may disagree with other people,
and maybe they're smarter,
maybe they work harder. >> Right. >> So
they won't always minimize their risk. The CAPM model is an abstraction,
an idealization. And it assumes that there are well-defined
probabilities for everything. But in fact, I don't think anyone behaves
entirely in accordance with this model. I'm thinking of it as, it's actually a
fabulous model as a first
step in thinking about financial markets. Because it can prevent you
from making a lot of mistakes.