[ Music ] >> Hi. I'm Professor Scott Weisbenner at the University of Illinois and this is module two of my course on investments. So I thought I'd start out this module with a question for you. So just take a step back and think, what location pops up when you think of the cradle of western civilization? The University of Illinois of course. Alright, sorry for the plug, I'm mandated to say it. Think back far, 2500 years farther in fact to Greece, Greek civilization, and when we think of Greece of course we think of the Parthenon in Athens, Socrates, Plato, Aristotle, the Greek alphabet, and within the Greek alphabet the two most important letters were put in the most prominent position; the first two slots, alpha and beta. Fast forward 2500 years to the world of finance today, alpha and beta still are very prominent. Okay? You don't trust me? Fine, just look here in the world of academics. Everyone is trying to generate alpha or at least write about people who are trying to generate alpha. Mutual fund performance, an inventive to generate alpha. Do hedge funds deliver alpha? Alpha's front and center on financial screens, so here this is taken from Morningstar.com, we're looking at the Fidelity Magellan Fund, we're looking at a regression analysis here with things like r squared beta, alpha here, alpha -2.4, Fidelity Magellan Fund underperforming its benchmark by -2.4% per year or the last 10 years. Don't worry. At the end of module two you'll be all on top of this. Beta's front and center. This was taken on the first screen of Finance.Yahoo when you type in the Tesla Motor stock tickers. Tesla's beta, 1.44, you can see this is a stock price as of May 2015. Whenever you look at this I don't know if the price will be up or down. Alright? Panera Bread, beta here much lower, 0.3. Why the difference? Panera way below one, Tesla greater than one when it comes to beta. Why is beta so provocative? Are the reports of beta's death premature? Is beta dead again? If beta's dead where is the corpse? Very mysterious. And what? There's this thing called smart beta? We're going to address all these topics about the Capital Asset Pricing Model, developing it, interpreting it and then implementing it in examples in Excel to evaluate the performance of various securities. All of this is happening in module two. We already got the objectives and overview done by a trip back to Greece. I'm sorry, I have to admit after being a finance professor, I always wanted to be deep voice guy on a commercial and I got my opportunity to kind of check that on the to do list. Second topic, Separation Theorem of Investments. So this you can view as like the John Vogel of Vanguard view of the world. The Separation Theorem of Investments very elegant says that as an investor all you have to worry about is breaking your portfolio between two funds; a risk free asset fund like Treasury bills and the market portfolio. If you love risk you'll invest a lot in the market, if you don't like risk you'll invest most in Treasury bills but all investors are holding some combination of the market portfolio and the risk free asset. Examples of reducing portfolio risk, how can you reduce a portfolio of adding, can you reduce a portfolio by adding more assets to it? And a key determination of whether the answer is yes or no will be how correlated are these assets with each other and we'll kind of go through a fun example with a gambling trip to [inaudible]. And then finally we're getting to the development of the Capital Asset Pricing Model, CAPM. Dates back to the 1960's, still a gold standard at least of an introduction to asset pricing models and an introduction to more sophisticated asset pricing models. You really start with the CAPM and for my money it still has the best economic intuition behind it. Maybe that's why a lot of Nobel Prizes in economics were awarded for people's work developing the Capital Asset Pricing Model in the 1960's. In section 2-5 we're going to do applications of the Capital Asset Pricing Model. Let's look at the stock returns at Coca Cola. Do a Capital Asset Pricing Model analysis of those returns to determine what should investors have as a benchmark return for Coca Cola. How much is Coca Cola surpassed or fell short of the benchmark established by the Capital Asset Pricing Model? Evaluation of the famous small value stock investment strategy over the last 88 years, 1927 to 2014. So we're looking at a group of stocks representing firms that are small in size, small market value of equity but also have a high book to market ratio like a small cement company. How do we view that investment strategy in a Capital Assets Pricing Model view of the world, and then we'll introduce this Three Factor Model as another way to evaluate the return's and the performance's strategies. And to build up on that we'll have our assignment within this module, assignment three. This is a mystery. You have to put your detective cap on for this one. I will give you three securities, I'll give you their returns over the last 20 years, so 240 months of returns, by doing a Capital Asset Pricing Model regression analysis, by doing a Three Factor Model analysis you're going to be able to tell at least the investment style, the characteristics of this security and then maybe by looking at its performance, looking at the characteristics you can actually identify what the mystery security is. And as always I'll follow the assignment up with a discussion, and then finally cap things off so we can look back, see what we've accomplished, review in section 2-8. For those of you who are taking this course for high engagement, who are taking the course to get University of Illinois credit, as always we have supplemental materials for you in this module, further practice with the Capital Asset Pricing Model and the Three Factor Model by evaluating the performance even more mystery security. So once you're done with this you're going to be very adept at interpreting what's alpha, what's beta, what are the various betas in the Three Factor Model represent and how can we use them to identify the securities, evaluate performance. Practical knowledge and experiences that you'll take away from module two, understanding the Separation Theorem of Investment and why people like John Vogel at Vanguard say this is really, you know, kind of all you need to know, just keep life simple, allocate assets across a couple funds, a risk free fund, a stock market fund, let your risk aversion decide the asset allocation. Don't worry about trying to find the, you know, kind of needle in the haystack of active management, just do an allocation based on your risk aversion between Treasury bills, risk free asset and the stock market, the risky asset. We'll get an in depth knowledge of the Capital Asset Pricing Model, what does alpha represent, what does beta represent? They were the first two letters in the Greek alphabet for a reason. They're the first two letters in finance for a reason. We'll be very adept at understanding what they mean at the end of this module. And then finally practice estimating and analyzing regressions with real world data and interpreting what the various regression coefficients mean and imply about the security or asset that we're analyzing. [ Silence ]