Portfolio Theory – Part 2 (Risk Definition)
In this video I provide a definition of risk.
VIDEO SUMMARY
In this video we’re going to continue talking about portfolio theory and I am going to give you a definition of risk. Now this is going to be one of my most important videos. I have talked about risk a lot in these videos but I have talked about it in a very conceptual way. What I am going to give you in this video is a mathematical definition of risk. If you can grasp this concept, it enables you to do all kinds of cool things in finance. Once you have that mathematical understanding you can start using your understanding of risk in financial modeling, in economic simulations, and in portfolio theory.
Let us put up the definition. In finance we describe risk as the likely variance from the current price. So what does that mean? I am going to give you an example and we are going to walk through this step-by-step so you understand what we are talking about here. Let us use an example. Let us say you are looking at an investment opportunity. You see this opportunity for a future cash flow of 120 dollars. If you make your investment you can get this future cash flow of a hundred and twenty dollars and you assess the riskiness of this at around twenty percent. So how much are you willing to pay for this investment? Well we know we can use the present value formula and we can calculate 120 dollars at twenty percent risk. We can discount that amount back to what you would be willing to pay today and that would be a hundred dollars because the present value formula. We say a hundred times 1.2 equals 120. So here we know we would be willing to pay 100 bucks for this investment. So we go out into the marketplace and we would buy this investment. We are holding it now at a hundred dollars at twenty percent risk. So if we look at our current situation, what we have is the hundred dollars, and we have this assumption that in the future it is going to be worth 120. We describe this risk, the twenty percent risk, as this variance of how we are going to get from a hundred dollars to 120. That is what we are talking about here: the uncertainty of my current investments changing into the future. It is that uncertainty that we are talking about and we can describe it as variance. The variance should reflect that twenty percent change that our assumptions are based on. So we are expecting this twenty percent change upward, and if it could be a twenty percent change upward you better believe it could be a twenty percent change down. So what you end up with are these zones. These are zones of potential prices into the future and, in this case, it is a plus or minus twenty percent. But riskier investments would have wider zones, while less risky investments would have smaller zones because there is more certainty of where those prices are going to end up.
This is a really huge concept to understand. When we are dealing with our investments, we are dealing with these zones of possible price fluctuations into the future. These zones are based on our assumptions. Now I want to take a second and talk about the fact that these are assumptions. If you look back at the definition, it is the likely variance from the current price. There is no guarantee where the price is going to end up. It could be a lot more. It could be a lot less. But that is not the point of what we are doing here. What we are doing is we are trying to specify what the most likely outcome where we think it is going to end up. What really is our amount of certainty with those predictions? So when we put all of this together what we are really doing is we are trying to quantify our assumptions and that allows us to predict the future. Because now we are sitting here and we have this understanding now of our investments. We have an understanding of where they are likely to end up. Now that I have that data, that knowledge, it enables me to improve the strategic decisions I am making today about my finances and that is the goal. That is really what we are doing in portfolio theory. In portfolio theory, you are looking at your investments. You have all these investments, and what you want to do is you want to say, “okay, each one of these investments, where do I think it is going to end up in the future?” Knowing that then allows you to make smart decisions on how to put your portfolio together today to maximize your profit.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.