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Hello, I'm Dr. Michael McDonald.
I'm an Associate
Professor of Finance
at Fairfield University
in Fairfield,
Connecticut in the
United States.
Today, I'd like to
talk to you about
the world's largest
asset manager,
BlackRock, and specifically
the process of
using what are called
factor models in investing.
Let's get started, shall we?
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Now, we talk about business.
There are lots of different
sources of risk in returns.
Business risk, financial
risk, market risk,
including things like interest
rates or exchange rates.
We've got liquidity risk,
we have sovereign risk.
We have a multitude of
different risk factors
to contend with.
Investors don't have a lot of
options to deal with risk.
But one good tool that we
do have to mitigate risk
in general, is what we refer
to as diversification.
Investors can combine
assets to form portfolios.
And then the portfolio
return generally has
less variability than
individual asset returns.
Now, risk reduction within
the portfolio depends
on what we call the
covariance among returns.
Basically, the idea is that
we need to have assets that are
diversified from one another.
They don't move in
sync with one another.
To illustrate this
using a stupid example,
if we have two
stocks and they both
are going up or down by
the same amount on a given day.
On any given day,
stock A moves up by 1%
and stock B also moves up by 1%.
Or stock B moves down by 1% and
stock A also moves down by 1%.
If they're tied
together like that,
there's no value in having
both stocks A and B
in the portfolio.
They're not going to provide any
diversification benefit
against one another.
That's the basic idea behind
diversification and
forming these portfolios.
Now, the concept here is that
we add an asset with
a return that's
less than perfectly
correlated with
the rest of the portfolio.
That is, where it doesn't
simply move in sync
with the rest of
the portfolio and this
reduces total risk.
From there, once we've gotten
all the benefits we can
from diversification,
we can capture our
remaining risks
in what we refer to as factors.
These factors should be
priced into a stock.
