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Principles of finance ah la shmoop variants and co variance

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will human beings like to live in a calm financial

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world We seek relatively low variability in our daily lives

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least when it comes to our pension or retirement money

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We've invested it's a lot of stress not knowing where

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your rent money is coming from or if you'll be

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able to feed your kids next month or if you'll

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finally be able to buy a new car window to

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replace that patchwork of duct tape So predictability in cash

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flows and cash coming to you and reliability in your

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long term retirement The quality of life you lead Yeah

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that carries a big premium in our society We generally

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want to mollify volatility And if we're thinking about our

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personal investments well then we want good long term investments

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But one who's variations offset one another at least a

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little bit Well what does all this mean Well think

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about a tiny tale of two industries the legal drug

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industry and the washer dryer industry Vastly different characteristics here

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But each industry is needed and it has a decent

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place to exist for an investor for a long time

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And there are good companies in each area worth owning

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like what are the odds We still have colds and

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dirty clothes in twenty years You know pretty good wealthy

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economy generally goes long and its gentle booms and busts

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over seven a ten year cycles ish that boom and

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bust cycle greatly effects when people choose upgrade to a

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new washing machine when times were good while they spend

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the dough they buy when times are bad while they

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just fix their old machine or try to find a

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water polo player stomach to you know do the wash

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on manually But when people are sick well they don't

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care what the economy is doing They want the drugs

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pain other than in certain video studios in van nuys

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california is not optional They will pay up in good

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times or bad for those legal drugs so drugs are

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generally a steady state business good economy or bad they

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grow up whatever percent per year they're going to grow

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in the act more or less independently of what the

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economy is doing So a portfolio that includes investments in

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a drug company it's kind of stabilized by it it

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just grows along at some modest percentage each year and

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it doesn't have awesome years like the washing machine company

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and it doesn't have terrible years like the washing machine

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company just kind of goes along stabilize it But what

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about a hedge What would be a direct opposite or

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variant of washing machines Like what does well in a

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bad economy Well how about a grocery couponing company Yeah

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when times get tough people pay more attention to clipping

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coupons to save money at the grocery store and that

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business often booms when times are bad So the coupons

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company is a co variant of the washing machine company

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and note that all of these companies can be equally

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good long term investments it's more about the long and

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winding nous of the road that they travel to eventually

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get there Five dollar word alert coefficient of variation Well

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we have myriad choices in a portfolio we can put

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together when we're investing and we'd better get on this

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because loving rich old uncle ari is coughing a lot

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more lately than he did six months ago Yeah we

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may have big portfolios coming our way to build soon

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We have a tool to help us figure out the

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next level of granularity in the investment portfolio we're assembling

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It's called the coefficient of variation and it maps the

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amount of risk we took to produce a given investing

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performance For example if we bought five dollars worth of

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lottery tickets at seven eleven and we want one hundred

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million dollars well what does that mean Well yes it's

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great that we want We're gonna go shopping for yachts

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and maybe a jet But didn't we take an insane

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amount of risk to produce that lottery winning ticket like

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it was one in a billion odds tto win and

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we got that one in twenty million hitter there Yeah

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well just because you're now rich does that really mean

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you know what you're doing Is an investor Well financial

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journalists will think so they'll talk about what a great

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lottery picker you are because well you know history and

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journalism is written by the wind right But really investors

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will likely question your wisdom while they're separately lauding your

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luck and leaving you to pick up the dinner check

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and think about that we had like a one in

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a billion chance of winning that lottery ticket So in

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theory that five dollars quote investment unquote should have produced

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a win of five billion dollars to simply equal the

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odds but we only won one hundred million dollars in

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the risk reward scenario didn't make any sense but we

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did it and we want are we smart No lucky

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ludicrously like insanely lucky so our coefficient here would be

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extremely hi mathematically the coefficient of variation is just a

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standard deviation divided by the expected return that thing remember

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our rap album example versus just buying an index fund

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You know if you don't go back and watch that

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video please given almost the same expected returns we'll hopefully

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the clarity obviousness of just investing in the index fund

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is easy way better than the rap album for our

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purposes here let's just ignore the details and how we

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calculate the nitty and the gritty of standard deviation contextually

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in a variety of portfolios and just cut to the

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big idea here How to calculate the coefficient of variation

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so you haven't expected return of ten percent from the

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rap album with standard deviation of thirty percent i eat

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lots of beta or volatility and potential outcomes like it

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could go bankrupt and give you zero Or you might

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make five times your money or a five hundred percent

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return And in the index fund scenario you have expected

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return of ten percent with standard deviation of only ten

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percent So the coefficient of variation in the rap album

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scenario is point three divided by point one or three

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And the coefficient of variation in the index fund scenario

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is point One divided by point once was just one

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night Well easy choice now illustrated for you Mathematically at

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no extra charge You go with the index fund and

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you buy your self esteem enhancements with the cash you

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save And maybe then you could just buy the rap

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album on itunes instead and feel good about all that

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