1 00:00:00,090 --> 00:00:02,430 The following content is provided under a Creative 2 00:00:02,430 --> 00:00:03,820 Commons license. 3 00:00:03,820 --> 00:00:06,030 Your support will help MIT OpenCourseWare 4 00:00:06,030 --> 00:00:10,120 continue to offer high quality educational resources for free. 5 00:00:10,120 --> 00:00:12,690 To make a donation or to view additional materials 6 00:00:12,690 --> 00:00:16,620 from hundreds of MIT courses, visit MIT OpenCourseWare 7 00:00:16,620 --> 00:00:17,820 at ocw.mit.edu. 8 00:00:26,230 --> 00:00:29,060 ANDREW W. LO: So on behalf of the Sloan School 9 00:00:29,060 --> 00:00:34,840 I want to welcome all of you to 15.401 Finance Theory. 10 00:00:34,840 --> 00:00:40,340 This course is meant for first year MBA students. 11 00:00:40,340 --> 00:00:42,280 And so that's the focus, and I'm going 12 00:00:42,280 --> 00:00:46,050 to assume that that's the background that all of you 13 00:00:46,050 --> 00:00:46,990 will have. 14 00:00:46,990 --> 00:00:49,640 We may have a few other students in the class, 15 00:00:49,640 --> 00:00:53,020 but primarily it will be first year MBAs who 16 00:00:53,020 --> 00:00:57,280 are thinking about a career in finance, 17 00:00:57,280 --> 00:00:58,780 as well as those of you who aren't 18 00:00:58,780 --> 00:01:02,140 sure about a career in finance but are curious about it. 19 00:01:02,140 --> 00:01:05,170 Hopefully over the next 13 weeks we'll 20 00:01:05,170 --> 00:01:08,850 be able to satisfy that curiosity. 21 00:01:08,850 --> 00:01:12,090 I want to start by talking a little bit 22 00:01:12,090 --> 00:01:17,940 about what finance is, and how I got interested in it, 23 00:01:17,940 --> 00:01:20,520 because I think it's often helpful in order 24 00:01:20,520 --> 00:01:23,250 to motivate a subject to get a sense of how 25 00:01:23,250 --> 00:01:28,830 somebody else decided to choose this as a profession. 26 00:01:28,830 --> 00:01:31,080 To do that I have to go back a little bit, 27 00:01:31,080 --> 00:01:33,910 and give you some background about 28 00:01:33,910 --> 00:01:37,110 my own educational experiences. 29 00:01:37,110 --> 00:01:42,270 So let me start by mentioning that I've 30 00:01:42,270 --> 00:01:45,330 been at MIT for the past 20 years, 31 00:01:45,330 --> 00:01:48,540 and been in the finance group all that time. 32 00:01:48,540 --> 00:01:51,730 Before that I taught at the Wharton School for four years. 33 00:01:51,730 --> 00:01:53,940 And before that, I got my PhD in economics 34 00:01:53,940 --> 00:01:58,230 from Harvard University, and then graduated in 1980 35 00:01:58,230 --> 00:02:02,100 from Yale also majoring in economics. 36 00:02:02,100 --> 00:02:06,360 And during that time I've learned an enormous amount 37 00:02:06,360 --> 00:02:09,389 both about finance and the real world, 38 00:02:09,389 --> 00:02:11,970 but one of the things that I keep coming back to 39 00:02:11,970 --> 00:02:15,390 is the fact that the finance field 40 00:02:15,390 --> 00:02:20,460 is almost unique in how it applies to practical management 41 00:02:20,460 --> 00:02:21,880 problems. 42 00:02:21,880 --> 00:02:25,260 And what I want to try to do over the next 13 weeks 43 00:02:25,260 --> 00:02:29,010 is to convince you of the fact that finance 44 00:02:29,010 --> 00:02:31,140 is in fact, the most important subject 45 00:02:31,140 --> 00:02:33,420 that you'll ever encounter. 46 00:02:33,420 --> 00:02:37,470 That in fact, finance is at the core of everything 47 00:02:37,470 --> 00:02:41,370 that you will ever do in business and in management. 48 00:02:41,370 --> 00:02:44,250 Now that's a tall order I recognize, 49 00:02:44,250 --> 00:02:45,780 and I suspect that some of you are 50 00:02:45,780 --> 00:02:49,050 quite skeptical about the role that finance might play 51 00:02:49,050 --> 00:02:50,590 in your own career objectives. 52 00:02:50,590 --> 00:02:53,914 And I know many of you have very different career objectives. 53 00:02:53,914 --> 00:02:55,830 And I'm not even trying to convince all of you 54 00:02:55,830 --> 00:02:58,260 to go into a career in finance, but I 55 00:02:58,260 --> 00:03:01,800 am trying to convince all of you that finance is really 56 00:03:01,800 --> 00:03:05,250 the lifeblood and the basic lingua 57 00:03:05,250 --> 00:03:07,890 franca of all of business. 58 00:03:07,890 --> 00:03:09,870 And that's one of the reasons why finance 59 00:03:09,870 --> 00:03:11,940 is such an important subject. 60 00:03:11,940 --> 00:03:14,800 Now before I begin, let me ask you a question. 61 00:03:14,800 --> 00:03:20,350 How many people have had no finance background whatsoever? 62 00:03:20,350 --> 00:03:22,150 Oh, that's great. 63 00:03:22,150 --> 00:03:25,554 I look forward to a challenge. 64 00:03:25,554 --> 00:03:26,970 But the other reason it's great is 65 00:03:26,970 --> 00:03:30,390 I have to tell you that it's a real privilege for me to be 66 00:03:30,390 --> 00:03:34,080 here in front of you to tell you about finance 67 00:03:34,080 --> 00:03:35,190 for the very first time. 68 00:03:35,190 --> 00:03:38,190 And it reminds me a little bit of my younger 69 00:03:38,190 --> 00:03:41,259 son who is an extraordinarily fussy eater, 70 00:03:41,259 --> 00:03:42,300 he's eight years old now. 71 00:03:42,300 --> 00:03:45,210 But ever since he was born he had some allergies, 72 00:03:45,210 --> 00:03:47,410 and he just refused to eat most of everything. 73 00:03:47,410 --> 00:03:51,210 In fact, my wife often says that my younger son is a vegetarian 74 00:03:51,210 --> 00:03:53,550 except he doesn't eat vegetables. 75 00:03:53,550 --> 00:03:55,110 So he's an incredibly fussy eater, 76 00:03:55,110 --> 00:03:57,540 and somehow when he was one year old 77 00:03:57,540 --> 00:04:00,870 he saw my older son eating an ice cream cone, 78 00:04:00,870 --> 00:04:03,307 and figured that that's something he ought to try. 79 00:04:03,307 --> 00:04:04,890 How he figured that out, I don't know. 80 00:04:04,890 --> 00:04:08,520 But he tasted it for the very first time, 81 00:04:08,520 --> 00:04:12,840 and you could see his face change in about four seconds 82 00:04:12,840 --> 00:04:17,490 from disgust to curiosity to absolute, you know, 83 00:04:17,490 --> 00:04:20,760 enthrallment with the taste and feel of ice cream. 84 00:04:20,760 --> 00:04:22,334 He just loved it thereafter. 85 00:04:22,334 --> 00:04:24,000 That's one of his major food groups now. 86 00:04:24,000 --> 00:04:25,560 It's ice cream. 87 00:04:25,560 --> 00:04:29,040 And so I feel privileged to be able to share that experience 88 00:04:29,040 --> 00:04:31,999 here in the sense that once you get a taste of finance, 89 00:04:31,999 --> 00:04:33,540 I think you're going to be incredibly 90 00:04:33,540 --> 00:04:35,460 excited and enthralled by the subject. 91 00:04:35,460 --> 00:04:37,140 Because it's one of the few subjects, 92 00:04:37,140 --> 00:04:39,900 in fact, that's the only subject that I've encountered 93 00:04:39,900 --> 00:04:43,860 that is both rigorous, it's extraordinarily 94 00:04:43,860 --> 00:04:47,850 challenging from a research and intellectual perspective, 95 00:04:47,850 --> 00:04:51,460 and at the end of the day it's extremely practical. 96 00:04:51,460 --> 00:04:53,670 In fact, I would say it's indispensable 97 00:04:53,670 --> 00:04:55,131 for financial management. 98 00:04:55,131 --> 00:04:57,630 So I'm going to try to convince you of that over the next 13 99 00:04:57,630 --> 00:05:01,770 weeks, and I'm going to do that by going over material 100 00:05:01,770 --> 00:05:04,515 that you will find indispensable. 101 00:05:04,515 --> 00:05:06,390 As many of you know, at the end of the course 102 00:05:06,390 --> 00:05:09,300 we have a ritual where we hand out teaching ratings. 103 00:05:09,300 --> 00:05:12,400 And among the finance faculty, among all the faculty, 104 00:05:12,400 --> 00:05:15,210 we're very concerned about good teaching. 105 00:05:15,210 --> 00:05:17,670 So these teaching ratings actually matter. 106 00:05:17,670 --> 00:05:21,390 And I've always thought that having a teaching rating 107 00:05:21,390 --> 00:05:23,550 survey at the end of the semester, 108 00:05:23,550 --> 00:05:25,320 is somewhat misguided. 109 00:05:25,320 --> 00:05:28,020 What I'd like to do, and what I've proposed 110 00:05:28,020 --> 00:05:30,360 hasn't been adopted yet, I propose 111 00:05:30,360 --> 00:05:32,610 to have teaching ratings submitted five 112 00:05:32,610 --> 00:05:35,100 years after a course is done. 113 00:05:35,100 --> 00:05:39,270 Now this may be a problem for some people who aren't 114 00:05:39,270 --> 00:05:40,920 up to speed in the classroom. 115 00:05:40,920 --> 00:05:43,920 But the reason I say this is, because it will only 116 00:05:43,920 --> 00:05:47,790 be after you get into your jobs, into your careers, 117 00:05:47,790 --> 00:05:51,240 before you realize how useful finance is. 118 00:05:51,240 --> 00:05:54,510 And five years from now, I suspect all of you 119 00:05:54,510 --> 00:05:55,950 will come back and say, gee, this 120 00:05:55,950 --> 00:05:58,325 is one of the most important courses you have ever taken. 121 00:05:58,325 --> 00:06:01,290 Not because of me, but because of the substance of what 122 00:06:01,290 --> 00:06:03,240 we're going to cover over the next 13 weeks. 123 00:06:03,240 --> 00:06:05,460 It's because of you and all of the work 124 00:06:05,460 --> 00:06:08,050 that you will put into this course. 125 00:06:08,050 --> 00:06:10,470 This will be the most challenging course 126 00:06:10,470 --> 00:06:11,910 you will ever love. 127 00:06:11,910 --> 00:06:14,400 So I-- stealing from the military-- 128 00:06:14,400 --> 00:06:16,740 I think that you'll really appreciate 129 00:06:16,740 --> 00:06:20,070 how the discipline of financial logic 130 00:06:20,070 --> 00:06:22,980 will help you to think smarter about all of your management 131 00:06:22,980 --> 00:06:26,312 decisions no matter what you decide to do with your careers. 132 00:06:26,312 --> 00:06:27,520 Now that's a very tall order. 133 00:06:27,520 --> 00:06:29,080 I've built up expectations. 134 00:06:29,080 --> 00:06:31,570 So I'm going to have to deliver over the next 13 weeks, 135 00:06:31,570 --> 00:06:34,070 and we'll see whether or not we can do that. 136 00:06:34,070 --> 00:06:37,150 But let me start now by talking about what 137 00:06:37,150 --> 00:06:39,120 we're going to cover today. 138 00:06:39,120 --> 00:06:41,940 I want to start with a little bit of motivation, 139 00:06:41,940 --> 00:06:44,430 and then talk about the dramatis personae. 140 00:06:44,430 --> 00:06:46,890 These are the cast of characters that we're 141 00:06:46,890 --> 00:06:50,670 going to be focusing on over the next 13 weeks. 142 00:06:50,670 --> 00:06:53,400 And then I'm going to lay out the fundamental challenges 143 00:06:53,400 --> 00:06:54,640 of financial analysis. 144 00:06:54,640 --> 00:06:58,210 It turns out there are only two. 145 00:06:58,210 --> 00:07:01,000 There are only two challenges in financial analysis, 146 00:07:01,000 --> 00:07:03,430 and once you figure both of those out, you're done. 147 00:07:03,430 --> 00:07:05,440 So if by chance you can figure that out 148 00:07:05,440 --> 00:07:07,023 before the end of the class, you don't 149 00:07:07,023 --> 00:07:10,160 need to come back for the rest of the lectures. 150 00:07:10,160 --> 00:07:13,010 Then I'm going to turn to providing you 151 00:07:13,010 --> 00:07:15,650 with a framework for thinking about these financial 152 00:07:15,650 --> 00:07:16,970 challenges. 153 00:07:16,970 --> 00:07:19,910 To me it's very important to have a framework to start with, 154 00:07:19,910 --> 00:07:21,770 because I like to organize my thoughts 155 00:07:21,770 --> 00:07:23,999 into things that I know and things that I don't know. 156 00:07:23,999 --> 00:07:26,540 And of the things that I know, how did it relate to the stuff 157 00:07:26,540 --> 00:07:28,790 that I already knew, or thought I knew. 158 00:07:28,790 --> 00:07:31,700 So I want to give you a sense of that kind of framework 159 00:07:31,700 --> 00:07:34,340 to think about financial analysis upfront. 160 00:07:34,340 --> 00:07:38,230 You probably won't fully appreciate it at this point, 161 00:07:38,230 --> 00:07:42,126 but sometime over the next 13 weeks you will get it. 162 00:07:42,126 --> 00:07:43,500 And so I want to give that to you 163 00:07:43,500 --> 00:07:46,410 so that you can start thinking about it subconsciously, 164 00:07:46,410 --> 00:07:48,810 unconsciously, and then eventually you 165 00:07:48,810 --> 00:07:52,640 will understand how all the pieces fit together. 166 00:07:52,640 --> 00:07:55,640 I then want to talk about the importance 167 00:07:55,640 --> 00:07:58,250 of two aspects of financial analysis 168 00:07:58,250 --> 00:08:01,400 that make finance different from every other discipline you 169 00:08:01,400 --> 00:08:04,940 will ever encounter here at MIT and elsewhere. 170 00:08:04,940 --> 00:08:08,700 And that is time and risk. 171 00:08:08,700 --> 00:08:10,500 Without those two factors it turns out 172 00:08:10,500 --> 00:08:13,990 that finance is actually done. 173 00:08:13,990 --> 00:08:16,830 In other words, there's no real research challenges, 174 00:08:16,830 --> 00:08:21,810 no open questions left once you eliminate time and risk. 175 00:08:21,810 --> 00:08:24,300 Put in another way, the only reason 176 00:08:24,300 --> 00:08:27,180 that there exists a finance department, and finance 177 00:08:27,180 --> 00:08:30,630 faculty, and finance journals, and a finance industry, 178 00:08:30,630 --> 00:08:34,710 the only reason is because of time and risk. 179 00:08:34,710 --> 00:08:36,450 So I'm going to come back to that. 180 00:08:36,450 --> 00:08:40,710 Then I'm going to conclude by giving you the six 181 00:08:40,710 --> 00:08:42,480 basic principles of finance. 182 00:08:42,480 --> 00:08:44,760 These are principles that you will encounter 183 00:08:44,760 --> 00:08:47,730 in all of your finance courses for the rest of your stay 184 00:08:47,730 --> 00:08:49,480 at MIT and elsewhere. 185 00:08:49,480 --> 00:08:51,510 These are the ideas, the fundamental ideas, 186 00:08:51,510 --> 00:08:53,010 that have shaped financial markets 187 00:08:53,010 --> 00:08:56,430 and that are at the root cause of all of the financial market 188 00:08:56,430 --> 00:08:59,370 innovations, as well as all of the financial market crises 189 00:08:59,370 --> 00:09:01,740 that we've seen including what's been going on 190 00:09:01,740 --> 00:09:04,290 over the last several months in the subprime mortgage market. 191 00:09:04,290 --> 00:09:06,623 In fact, we're going to talk about the subprime mortgage 192 00:09:06,623 --> 00:09:09,360 problems after we cover fixed income securities. 193 00:09:09,360 --> 00:09:11,550 Right now I suspect most of you know 194 00:09:11,550 --> 00:09:14,280 that there's something going on, know that it's bad stuff, 195 00:09:14,280 --> 00:09:16,260 but you don't know why, how, where, when, 196 00:09:16,260 --> 00:09:18,160 and what to do about it. 197 00:09:18,160 --> 00:09:21,960 Well, in about five lectures, you will. 198 00:09:21,960 --> 00:09:25,110 It's not complicated, but it's different from anything 199 00:09:25,110 --> 00:09:26,580 that you've ever encountered. 200 00:09:26,580 --> 00:09:28,920 And in fact, financial analysis, I suspect, 201 00:09:28,920 --> 00:09:32,130 is different from anything most of you have ever encountered. 202 00:09:32,130 --> 00:09:34,260 I'm hoping that by the end of the course, 203 00:09:34,260 --> 00:09:38,370 it will change the way you think about everything. 204 00:09:38,370 --> 00:09:41,160 And again, I recognize that that's a tall order, 205 00:09:41,160 --> 00:09:42,570 but you tell me 13 weeks from now 206 00:09:42,570 --> 00:09:45,240 whether or not I've delivered. 207 00:09:45,240 --> 00:09:47,400 And then I'll conclude by talking about the course 208 00:09:47,400 --> 00:09:49,110 overview, and then finally I want 209 00:09:49,110 --> 00:09:51,174 to say a few words about how as a student 210 00:09:51,174 --> 00:09:52,840 you can get the most out of this course. 211 00:09:52,840 --> 00:09:56,130 This is a part of the lecture that I've always 212 00:09:56,130 --> 00:09:59,580 felt is critical at the very start of a course 213 00:09:59,580 --> 00:10:02,910 like this, because there are a number of challenges 214 00:10:02,910 --> 00:10:04,950 that you will face over the next 13 215 00:10:04,950 --> 00:10:07,239 weeks regarding this material. 216 00:10:07,239 --> 00:10:08,780 And I've always thought that it would 217 00:10:08,780 --> 00:10:12,676 be helpful for the instructor to let me know where 218 00:10:12,676 --> 00:10:14,050 those challenges might come from, 219 00:10:14,050 --> 00:10:16,650 and what I should do in advance to prepare 220 00:10:16,650 --> 00:10:17,580 for those challenges. 221 00:10:17,580 --> 00:10:20,950 So I'm going to do that at the end of this hour and a half. 222 00:10:20,950 --> 00:10:23,740 For next time I'd like you to read Brealey and Myers, 223 00:10:23,740 --> 00:10:25,660 chapters one and two. 224 00:10:25,660 --> 00:10:30,320 We are going to be covering that today as well as next Monday. 225 00:10:30,320 --> 00:10:32,710 So please keep up with your readings. 226 00:10:32,710 --> 00:10:34,440 And at the end of this lecture, I 227 00:10:34,440 --> 00:10:37,780 will talk a bit about the course requirements 228 00:10:37,780 --> 00:10:41,770 and other aspects of the course mechanics. 229 00:10:41,770 --> 00:10:44,990 Any questions? 230 00:10:44,990 --> 00:10:47,300 All right, let me start with some motivation 231 00:10:47,300 --> 00:10:50,000 about why you might want to study finance 232 00:10:50,000 --> 00:10:52,610 and why finance is so important. 233 00:10:52,610 --> 00:10:56,570 And I've always found that with motivation it's really best 234 00:10:56,570 --> 00:10:59,210 to do it in a personal way. 235 00:10:59,210 --> 00:11:01,640 That is, to try to find an individual or a group 236 00:11:01,640 --> 00:11:05,810 of individuals that personify a particular discipline 237 00:11:05,810 --> 00:11:06,657 or endeavor. 238 00:11:06,657 --> 00:11:08,240 And so there are three people that I'd 239 00:11:08,240 --> 00:11:09,920 like to introduce you to. 240 00:11:09,920 --> 00:11:13,610 I suspect you'll know at least two out of the three, 241 00:11:13,610 --> 00:11:17,020 but my guess is you won't know all of them. 242 00:11:17,020 --> 00:11:18,550 The first person-- oh, before I do 243 00:11:18,550 --> 00:11:21,250 that, I want to introduce a very simple definition of what 244 00:11:21,250 --> 00:11:22,510 finance is. 245 00:11:22,510 --> 00:11:23,950 So this is the very first equation 246 00:11:23,950 --> 00:11:25,450 that you'll ever see in this course, 247 00:11:25,450 --> 00:11:27,370 and there'll be many others of course. 248 00:11:27,370 --> 00:11:31,870 But the first expression of exactly what is finance 249 00:11:31,870 --> 00:11:37,750 is this, finance is simply equal to mathematics plus money. 250 00:11:37,750 --> 00:11:40,480 Now that suggests that mathematics as a discipline 251 00:11:40,480 --> 00:11:42,190 is equal to finance without the money, 252 00:11:42,190 --> 00:11:46,090 but really that's not my point. 253 00:11:46,090 --> 00:11:49,630 Although it's true by the way, that's not my point. 254 00:11:49,630 --> 00:11:52,150 My point is that finance is the study, 255 00:11:52,150 --> 00:11:56,770 the systematic and disciplined study of financial transactions 256 00:11:56,770 --> 00:11:58,610 of money. 257 00:11:58,610 --> 00:12:01,356 Now when you see this you might think, well, gee, 258 00:12:01,356 --> 00:12:03,230 I don't really have a strong math background. 259 00:12:03,230 --> 00:12:05,750 Maybe I'm in the wrong place or the wrong class. 260 00:12:05,750 --> 00:12:10,670 And I want to explain to you that that's completely 261 00:12:10,670 --> 00:12:14,090 inaccurate, and inappropriate. 262 00:12:14,090 --> 00:12:16,610 When I say mathematics, I'm actually 263 00:12:16,610 --> 00:12:20,390 talking about a very wide range of mathematics. 264 00:12:20,390 --> 00:12:23,240 Everything from the extraordinarily 265 00:12:23,240 --> 00:12:28,310 complex and profound to the extremely pedestrian 266 00:12:28,310 --> 00:12:29,720 and obvious. 267 00:12:29,720 --> 00:12:34,340 So literally the range from differential geometry 268 00:12:34,340 --> 00:12:35,870 and partial differential equations 269 00:12:35,870 --> 00:12:40,430 on one end of the spectrum to arithmetic and high school 270 00:12:40,430 --> 00:12:43,410 algebra at the other end of the spectrum. 271 00:12:43,410 --> 00:12:46,340 Now since this is an introductory finance class, 272 00:12:46,340 --> 00:12:48,570 I assume that you know nothing. 273 00:12:48,570 --> 00:12:51,120 What I mean by that is, I assume that there 274 00:12:51,120 --> 00:12:54,330 are no prerequisites that you have other than what it took 275 00:12:54,330 --> 00:12:56,370 for you to get into here, which is 276 00:12:56,370 --> 00:12:58,090 pretty substantial by the way. 277 00:12:58,090 --> 00:13:01,770 Congratulations to all of you for getting in. 278 00:13:01,770 --> 00:13:04,590 But we're not requiring that you have 279 00:13:04,590 --> 00:13:09,540 any background in quantitative analysis, computers, 280 00:13:09,540 --> 00:13:11,220 upper level mathematics. 281 00:13:11,220 --> 00:13:15,250 So when I say finance is equal to mathematics plus money, 282 00:13:15,250 --> 00:13:17,320 there's a variety of kinds of mathematics 283 00:13:17,320 --> 00:13:18,910 that can be appropriate for creating 284 00:13:18,910 --> 00:13:23,540 an extraordinarily profitable career in this industry. 285 00:13:23,540 --> 00:13:27,100 And now here are the three examples. 286 00:13:27,100 --> 00:13:30,478 Anybody know who James Simons is? 287 00:13:30,478 --> 00:13:32,434 Who is he? 288 00:13:32,434 --> 00:13:34,390 AUDIENCE: Well, I know about Renaissance. 289 00:13:34,390 --> 00:13:36,640 ANDREW W. LO: You know about Renaissance Technologies. 290 00:13:36,640 --> 00:13:39,010 Do you know what James Simons did before he started 291 00:13:39,010 --> 00:13:41,369 Renaissance Technologies? 292 00:13:41,369 --> 00:13:41,868 Yeah. 293 00:13:41,868 --> 00:13:43,270 AUDIENCE: He's a math professor. 294 00:13:43,270 --> 00:13:46,360 ANDREW W. LO: He's a math professor, that's right. 295 00:13:46,360 --> 00:13:49,620 James Simons is a math professor. 296 00:13:49,620 --> 00:13:51,100 Well, was a math professor. 297 00:13:51,100 --> 00:13:54,520 In fact, he was quite a well-known math professor. 298 00:13:54,520 --> 00:13:56,890 When I first heard of him, it wasn't 299 00:13:56,890 --> 00:13:58,510 because of Renaissance Technologies, 300 00:13:58,510 --> 00:14:00,850 which is a hedge fund that he started 301 00:14:00,850 --> 00:14:03,720 about 15 or 20 years ago. 302 00:14:03,720 --> 00:14:08,370 James Simons was a differential geometer who for many years 303 00:14:08,370 --> 00:14:10,740 was the chairman of the math department 304 00:14:10,740 --> 00:14:14,240 at Stony Brook in New York. 305 00:14:14,240 --> 00:14:20,000 And he authored with S.S. Chern a particular field of study 306 00:14:20,000 --> 00:14:24,020 in differential geometry called Chern-Simons theory, which 307 00:14:24,020 --> 00:14:26,240 has subsequently proved to be extraordinarily 308 00:14:26,240 --> 00:14:30,050 useful in an area of physics known as string theory. 309 00:14:30,050 --> 00:14:32,450 Extraordinarily abstract. 310 00:14:32,450 --> 00:14:38,520 And Simon started a hedge fund about 20 years ago. 311 00:14:38,520 --> 00:14:43,460 And this is probably the single most successful hedge fund 312 00:14:43,460 --> 00:14:47,300 in the history of the industry in terms of its performance 313 00:14:47,300 --> 00:14:48,770 record. 314 00:14:48,770 --> 00:14:52,610 Over the course of 15 or 20 years, 315 00:14:52,610 --> 00:14:55,340 he's put together a track record that has literally 316 00:14:55,340 --> 00:14:58,310 beaten every other hedge fund manager's track 317 00:14:58,310 --> 00:14:59,660 record by a lot. 318 00:14:59,660 --> 00:15:01,120 So it's not just a little bit. 319 00:15:01,120 --> 00:15:02,560 He's just sort of way out there. 320 00:15:02,560 --> 00:15:06,530 He's the Michael Phelps of quantitative investment 321 00:15:06,530 --> 00:15:08,060 strategies. 322 00:15:08,060 --> 00:15:10,910 By the way, just to give you a sense of how successful 323 00:15:10,910 --> 00:15:13,210 he has been. 324 00:15:13,210 --> 00:15:16,750 In 2006, two years ago, it was reported 325 00:15:16,750 --> 00:15:19,330 by Institutional Investor's Alpha Magazine-- 326 00:15:19,330 --> 00:15:21,830 this is a trade publication for the hedge fund industry-- it 327 00:15:21,830 --> 00:15:26,680 was reported that James Simons was the single most highly 328 00:15:26,680 --> 00:15:29,200 paid hedge fund manager that year 329 00:15:29,200 --> 00:15:35,055 with a take-home pay of $1.7 billion. 330 00:15:35,055 --> 00:15:38,700 Now, that's not wealth, that's income. 331 00:15:38,700 --> 00:15:39,595 That was on his W-2. 332 00:15:42,630 --> 00:15:45,300 That was one year's compensation. 333 00:15:45,300 --> 00:15:47,120 And he did it-- 334 00:15:47,120 --> 00:15:50,570 he did this by building a quantitative investment 335 00:15:50,570 --> 00:15:54,680 management company with 75 PhDs in mathematics, physics, 336 00:15:54,680 --> 00:15:57,110 computer science, and so on. 337 00:15:57,110 --> 00:16:00,620 And nobody, nobody knows what he does or how he does it. 338 00:16:00,620 --> 00:16:03,590 It's extraordinarily secret. 339 00:16:03,590 --> 00:16:07,500 But there's no doubt that he's incredibly successful. 340 00:16:07,500 --> 00:16:09,740 So that's one end of the spectrum. 341 00:16:09,740 --> 00:16:12,680 That kind of mathematics can make money, 342 00:16:12,680 --> 00:16:16,630 and can be extraordinarily relevant financial analysis. 343 00:16:16,630 --> 00:16:22,200 Now at the other end of the spectrum, we have this guy. 344 00:16:22,200 --> 00:16:25,240 You may have heard of him, Warren Buffett. 345 00:16:25,240 --> 00:16:28,630 He is currently the richest man on earth. 346 00:16:28,630 --> 00:16:33,040 In 2008 Forbes ranked him number one in terms of wealth. 347 00:16:33,040 --> 00:16:38,794 At the time, February of 2008, he was worth $62 billion. 348 00:16:38,794 --> 00:16:40,210 In fact, in a private conversation 349 00:16:40,210 --> 00:16:43,990 I was told that when Simons found out he said, really? 350 00:16:43,990 --> 00:16:44,920 $62 billion? 351 00:16:44,920 --> 00:16:45,990 How did he get that? 352 00:16:45,990 --> 00:16:47,350 It's amazing. 353 00:16:47,350 --> 00:16:50,320 That's an extraordinary amount of wealth for an individual 354 00:16:50,320 --> 00:16:51,190 to put together. 355 00:16:51,190 --> 00:16:54,610 And what's extraordinary about it, is how he did it. 356 00:16:54,610 --> 00:16:57,850 As many of you know Warren Buffett is an investor based 357 00:16:57,850 --> 00:17:00,130 in Omaha, Nebraska. 358 00:17:00,130 --> 00:17:06,099 His office is probably smaller than many of the conference 359 00:17:06,099 --> 00:17:07,869 rooms here at Sloan. 360 00:17:07,869 --> 00:17:10,660 The number of people he has working for him, I suspect, 361 00:17:10,660 --> 00:17:12,160 is fewer than many of you who have 362 00:17:12,160 --> 00:17:14,880 done your startups or plan to. 363 00:17:14,880 --> 00:17:17,310 He's got an extraordinarily small staff. 364 00:17:17,310 --> 00:17:19,200 Mainly it's Charlie Munger and him, 365 00:17:19,200 --> 00:17:22,170 and a couple of secretaries, and maybe 366 00:17:22,170 --> 00:17:27,140 a few accountants here and there, and lawyers of course. 367 00:17:27,140 --> 00:17:33,800 But what he does is to read company prospectuses, income 368 00:17:33,800 --> 00:17:35,930 statements, balance sheets. 369 00:17:35,930 --> 00:17:39,920 And with literally high school arithmetic 370 00:17:39,920 --> 00:17:43,890 he's built this incredible investment empire 371 00:17:43,890 --> 00:17:46,200 by looking at valuation. 372 00:17:46,200 --> 00:17:47,560 Simple accounting. 373 00:17:47,560 --> 00:17:50,220 Now I say simple accounting, but there's nothing simple 374 00:17:50,220 --> 00:17:52,420 about what he does. 375 00:17:52,420 --> 00:17:55,860 And so clearly he has certain skills 376 00:17:55,860 --> 00:17:58,380 that also involve mathematics, but not 377 00:17:58,380 --> 00:18:02,230 the kind of mathematics that James Simons uses. 378 00:18:02,230 --> 00:18:04,330 And finally, the third individual 379 00:18:04,330 --> 00:18:08,830 that I'd like to introduce you to is this fellow, Jack Welch. 380 00:18:08,830 --> 00:18:11,650 Now again, many of you know him or know of him. 381 00:18:11,650 --> 00:18:14,900 You know that he actually teaches a course here at Sloan. 382 00:18:14,900 --> 00:18:19,250 But you may not know that his PhD was actually 383 00:18:19,250 --> 00:18:21,400 in engineering. 384 00:18:21,400 --> 00:18:25,090 And he started out at General Electric in 1960. 385 00:18:25,090 --> 00:18:32,840 Became CEO in 1981, and at that time the revenues 386 00:18:32,840 --> 00:18:35,480 of General Electric was about $26 billion a year. 387 00:18:35,480 --> 00:18:39,790 So it was already a big and successful company. 388 00:18:39,790 --> 00:18:43,000 And Jack Welch took it over in 1981. 389 00:18:43,000 --> 00:18:47,470 At the time there were 400,000 employees for General Electric. 390 00:18:47,470 --> 00:18:50,950 Five years later, there were 300,000 employees 391 00:18:50,950 --> 00:18:52,180 at General Electric. 392 00:18:52,180 --> 00:18:53,666 He eliminated 100,000 jobs. 393 00:18:53,666 --> 00:18:56,290 That's one of the reasons why he developed the nickname Neutron 394 00:18:56,290 --> 00:18:59,260 Jack, because like a neutron bomb, 395 00:18:59,260 --> 00:19:03,290 he eliminated a huge segment of the population. 396 00:19:03,290 --> 00:19:08,020 But five years later with 300,000 employees, 397 00:19:08,020 --> 00:19:10,720 he increased the market value of General Electric 398 00:19:10,720 --> 00:19:12,370 by several fold. 399 00:19:12,370 --> 00:19:17,410 And at the end of his tenure in 2001, 20 years later, 400 00:19:17,410 --> 00:19:21,330 General Electric's revenues was not $26 billion, 401 00:19:21,330 --> 00:19:23,530 it was $130 billion. 402 00:19:23,530 --> 00:19:26,770 He increased it by a factor of 4 and 1/2 403 00:19:26,770 --> 00:19:28,720 over the course of 20 years. 404 00:19:28,720 --> 00:19:30,940 It's an extraordinary accomplishment 405 00:19:30,940 --> 00:19:32,960 for an individual. 406 00:19:32,960 --> 00:19:35,170 Now why do I put him up here? 407 00:19:35,170 --> 00:19:37,270 It's because one of the things that Welch 408 00:19:37,270 --> 00:19:39,020 did at General Electric, one of the things 409 00:19:39,020 --> 00:19:42,080 that he was extraordinarily good at, was making 410 00:19:42,080 --> 00:19:44,830 good decisions about investments, making 411 00:19:44,830 --> 00:19:49,180 good decisions about costs, being able to understand 412 00:19:49,180 --> 00:19:52,960 the language of finance despite the fact 413 00:19:52,960 --> 00:19:56,810 that he used none of his PhD skills in his job. 414 00:19:56,810 --> 00:20:00,110 He was an engineer by training, not a manager. 415 00:20:00,110 --> 00:20:02,680 He didn't go to management school, 416 00:20:02,680 --> 00:20:05,410 although he did a lot of executive education 417 00:20:05,410 --> 00:20:09,120 after his PhD. 418 00:20:09,120 --> 00:20:11,640 The reason that I give you these three cast of characters 419 00:20:11,640 --> 00:20:16,110 is because they are so different in what they do. 420 00:20:16,110 --> 00:20:18,450 They have such different backgrounds. 421 00:20:18,450 --> 00:20:21,270 They're all extraordinarily successful, 422 00:20:21,270 --> 00:20:23,690 but there's one thing in common. 423 00:20:23,690 --> 00:20:28,410 The thing in common is that they all understand innately, 424 00:20:28,410 --> 00:20:32,250 deeply, fundamentally, the language of finance. 425 00:20:32,250 --> 00:20:34,980 And what we're going to cover over the next 13 weeks, 426 00:20:34,980 --> 00:20:36,150 are the very basics. 427 00:20:36,150 --> 00:20:37,680 Things that they take for granted. 428 00:20:37,680 --> 00:20:43,030 Things that they use on a daily basis to do their jobs. 429 00:20:43,030 --> 00:20:45,540 So it's not to say that if you do well in this course 430 00:20:45,540 --> 00:20:48,240 you'll end up being one of these guys, 431 00:20:48,240 --> 00:20:51,720 but it's certainly a prerequisite I would say. 432 00:20:51,720 --> 00:20:54,450 There's nobody that's been successful in business, 433 00:20:54,450 --> 00:20:58,290 truly successful, without having an understanding, at least 434 00:20:58,290 --> 00:21:00,780 an innate or instinctive understanding, 435 00:21:00,780 --> 00:21:03,780 of the concepts that we're going to cover over the next 13 436 00:21:03,780 --> 00:21:04,950 weeks. 437 00:21:04,950 --> 00:21:06,150 So to me, that's exciting. 438 00:21:06,150 --> 00:21:10,200 Now again, I'm not trying to motivate you by greed. 439 00:21:10,200 --> 00:21:12,450 I'd rather motivate you by the intellectual challenge 440 00:21:12,450 --> 00:21:15,090 of finance, and there will be some extraordinarily 441 00:21:15,090 --> 00:21:16,800 challenging ideas. 442 00:21:16,800 --> 00:21:21,510 Ideas that are not natural for any of you at this point, 443 00:21:21,510 --> 00:21:24,780 but which I hope will be very natural 444 00:21:24,780 --> 00:21:27,960 at the end of this 13 weeks. 445 00:21:27,960 --> 00:21:30,960 So let me start with the cast of characters 446 00:21:30,960 --> 00:21:35,270 that we're going to be studying over the next 13 weeks. 447 00:21:35,270 --> 00:21:38,950 There are going to be four components of the economy 448 00:21:38,950 --> 00:21:40,200 that we're going to focus on. 449 00:21:40,200 --> 00:21:41,950 Now this is a flow diagram of the economy. 450 00:21:41,950 --> 00:21:44,560 Since we're at MIT we have to have flow diagrams 451 00:21:44,560 --> 00:21:46,030 at some point, right? 452 00:21:46,030 --> 00:21:49,900 So here's my version of a flow diagram. 453 00:21:49,900 --> 00:21:51,850 This is a flow model of the economy, 454 00:21:51,850 --> 00:21:54,220 and there are four components that 455 00:21:54,220 --> 00:21:55,990 comprise the financial system. 456 00:21:55,990 --> 00:21:59,560 Households, financial intermediaries, 457 00:21:59,560 --> 00:22:04,060 non-financial corporations, and then capital markets. 458 00:22:04,060 --> 00:22:06,150 Now obviously the economy is comprised 459 00:22:06,150 --> 00:22:09,270 of additional components like labor markets and product 460 00:22:09,270 --> 00:22:10,595 markets. 461 00:22:10,595 --> 00:22:11,970 We're not going to focus on that. 462 00:22:11,970 --> 00:22:14,178 Although there are certain financial aspects of those 463 00:22:14,178 --> 00:22:15,370 markets. 464 00:22:15,370 --> 00:22:17,790 Given that we only have 13 weeks, 465 00:22:17,790 --> 00:22:21,180 our attention will be spent on those four components, 466 00:22:21,180 --> 00:22:24,090 and I'm going to cover each of those four components, 467 00:22:24,090 --> 00:22:27,671 both in parallel and to a certain degree sequentially, 468 00:22:27,671 --> 00:22:28,170 all right? 469 00:22:28,170 --> 00:22:30,246 So I want you to be familiar with these four, 470 00:22:30,246 --> 00:22:31,620 because we're going to be talking 471 00:22:31,620 --> 00:22:35,490 about them interchangeably at various points in time. 472 00:22:35,490 --> 00:22:39,000 Financial analysis applies to all of these components 473 00:22:39,000 --> 00:22:40,780 in exactly the same way. 474 00:22:40,780 --> 00:22:43,320 But once you apply them to the specific context, 475 00:22:43,320 --> 00:22:46,350 the terminology may change, the particular applications 476 00:22:46,350 --> 00:22:47,430 may look different. 477 00:22:47,430 --> 00:22:49,920 What I'm going to try to teach you in this 13 weeks 478 00:22:49,920 --> 00:22:52,170 is the underpinning theories that 479 00:22:52,170 --> 00:22:55,710 unify all of the various different kinds of ideas. 480 00:22:55,710 --> 00:22:57,690 So these are the four components that we're 481 00:22:57,690 --> 00:23:01,510 going to be looking at from now and then. 482 00:23:01,510 --> 00:23:03,510 Now let me talk about the fundamental challenges 483 00:23:03,510 --> 00:23:04,009 of finance. 484 00:23:04,009 --> 00:23:06,970 I told you that there are only two, right? 485 00:23:06,970 --> 00:23:08,590 And here they are. 486 00:23:08,590 --> 00:23:11,374 There are two aspects of financial analysis 487 00:23:11,374 --> 00:23:12,790 that we're going to be focused on. 488 00:23:12,790 --> 00:23:17,500 The first is the valuation of assets. 489 00:23:20,140 --> 00:23:26,170 And the second is very simply the management of assets. 490 00:23:26,170 --> 00:23:27,040 That's it. 491 00:23:27,040 --> 00:23:29,090 That's all there is to it. 492 00:23:29,090 --> 00:23:33,017 Valuing and managing. 493 00:23:33,017 --> 00:23:34,850 And I can tell you exactly what the managing 494 00:23:34,850 --> 00:23:37,100 part is going to look like. 495 00:23:37,100 --> 00:23:40,910 Managing is going to involve figuring out which of two 496 00:23:40,910 --> 00:23:44,172 possibilities is more valuable. 497 00:23:44,172 --> 00:23:45,130 And then you know what? 498 00:23:45,130 --> 00:23:47,350 You take the more valuable option. 499 00:23:47,350 --> 00:23:48,430 That's it. 500 00:23:48,430 --> 00:23:50,820 That's all there is to it. 501 00:23:50,820 --> 00:23:55,670 Figuring out the value, that's going to be challenging. 502 00:23:55,670 --> 00:23:59,210 So we're going to take that first challenge 503 00:23:59,210 --> 00:24:03,290 to start with, and try to understand valuation. 504 00:24:03,290 --> 00:24:04,910 I'm going to argue that all business 505 00:24:04,910 --> 00:24:07,970 decisions, any kind of business decision, 506 00:24:07,970 --> 00:24:10,010 involves those two challenges. 507 00:24:10,010 --> 00:24:14,750 Valuing something, and then once you value it, 508 00:24:14,750 --> 00:24:20,180 make a decision on what you want to do with that value. 509 00:24:20,180 --> 00:24:21,740 This is why I've argued that finance 510 00:24:21,740 --> 00:24:24,281 is the most important subject, because literally any business 511 00:24:24,281 --> 00:24:26,270 decision that you will ever engage in, 512 00:24:26,270 --> 00:24:27,860 constitutes those two components. 513 00:24:27,860 --> 00:24:31,710 Valuation and management. 514 00:24:31,710 --> 00:24:36,570 Now valuation is going to be a challenge by itself, 515 00:24:36,570 --> 00:24:40,060 because it's not at all clear what value we're talking about. 516 00:24:40,060 --> 00:24:43,980 In other words, what is value? 517 00:24:43,980 --> 00:24:46,090 Is water valuable? 518 00:24:46,090 --> 00:24:47,920 Well, life can't be sustained without it. 519 00:24:47,920 --> 00:24:50,140 At least carbon based forms of life. 520 00:24:50,140 --> 00:24:52,640 So water is pretty valuable. 521 00:24:52,640 --> 00:24:54,650 But water is not that expensive. 522 00:24:54,650 --> 00:24:58,140 At least before Poland Springs came along. 523 00:24:58,140 --> 00:24:59,190 Now what about diamonds? 524 00:24:59,190 --> 00:25:03,000 As far as I know, humans do not need diamonds to survive, 525 00:25:03,000 --> 00:25:06,240 and yet diamonds are extraordinarily expensive. 526 00:25:06,240 --> 00:25:10,060 There are certain gems that are invaluable. 527 00:25:10,060 --> 00:25:11,510 Now how can that be? 528 00:25:11,510 --> 00:25:14,300 Clearly we have to think more carefully 529 00:25:14,300 --> 00:25:17,720 about what we mean by value. 530 00:25:17,720 --> 00:25:20,840 And of course, once value is established then 531 00:25:20,840 --> 00:25:24,130 management is relatively easy to do. 532 00:25:24,130 --> 00:25:28,690 Objectives plus valuations obviously leads to decisions. 533 00:25:28,690 --> 00:25:31,310 So once you tell me what you're trying to achieve, 534 00:25:31,310 --> 00:25:33,340 and then you value all the various different 535 00:25:33,340 --> 00:25:36,640 possibilities, then I can tell you what the right decision is. 536 00:25:36,640 --> 00:25:40,330 Pick the decision that is the most valuable for achieving 537 00:25:40,330 --> 00:25:43,470 the objectives that you want. 538 00:25:43,470 --> 00:25:45,680 Now that doesn't really help a lot 539 00:25:45,680 --> 00:25:49,010 if we can't apply this to specific contexts, 540 00:25:49,010 --> 00:25:52,414 and come up with specific value. 541 00:25:52,414 --> 00:25:54,080 So I want to hammer this home, and to do 542 00:25:54,080 --> 00:25:58,820 that I want to talk about how it is that financial markets helps 543 00:25:58,820 --> 00:26:03,260 us establish value through the price discovery mechanism. 544 00:26:03,260 --> 00:26:06,760 And to do that, I am going to do a simple demonstration. 545 00:26:06,760 --> 00:26:09,410 Now when I was growing up I went to one 546 00:26:09,410 --> 00:26:11,070 of these specialized high schools 547 00:26:11,070 --> 00:26:12,070 that focused on science. 548 00:26:12,070 --> 00:26:14,570 So we were always getting these various different kinds 549 00:26:14,570 --> 00:26:19,287 of neat demonstrations of the Tesla kind of coil. 550 00:26:19,287 --> 00:26:21,620 I've always been very jealous of these science teachers, 551 00:26:21,620 --> 00:26:23,750 because they have these cool demonstrations that we 552 00:26:23,750 --> 00:26:25,130 in finance don't. 553 00:26:25,130 --> 00:26:28,140 So I've developed a little demonstration of my own. 554 00:26:28,140 --> 00:26:30,770 It's a simple one that has to do with the price discovery 555 00:26:30,770 --> 00:26:32,840 mechanism, and because I teach two sections, 556 00:26:32,840 --> 00:26:34,010 I'm going to have to make it a little bit more 557 00:26:34,010 --> 00:26:35,240 involved than normally. 558 00:26:35,240 --> 00:26:37,190 So I need two volunteers. 559 00:26:37,190 --> 00:26:38,562 The first volunteer-- thank you. 560 00:26:38,562 --> 00:26:40,520 I'd like you to take these two pieces of paper, 561 00:26:40,520 --> 00:26:42,050 these are blank pieces of paper. 562 00:26:42,050 --> 00:26:45,432 On one of them write heads, and the other write tails. 563 00:26:45,432 --> 00:26:47,390 And then place them face down, and shuffle them 564 00:26:47,390 --> 00:26:50,010 so you don't know which is which. 565 00:26:50,010 --> 00:26:54,400 And I need another volunteer who has a coin that they can flip, 566 00:26:54,400 --> 00:26:55,340 because-- thank you. 567 00:26:55,340 --> 00:26:57,557 So as soon as he's done, I'm going 568 00:26:57,557 --> 00:26:58,640 to ask you to flip a coin. 569 00:26:58,640 --> 00:26:59,690 Do you have a coin by the way? 570 00:26:59,690 --> 00:27:00,314 AUDIENCE: Yeah. 571 00:27:00,314 --> 00:27:01,920 ANDREW W. LO: OK. 572 00:27:01,920 --> 00:27:04,510 I have two items here. 573 00:27:04,510 --> 00:27:07,050 One of which is going to be auctioned off in this section, 574 00:27:07,050 --> 00:27:08,800 and the other is going to be auctioned off 575 00:27:08,800 --> 00:27:09,830 in the later section. 576 00:27:09,830 --> 00:27:11,830 And since I don't know what your preferences are 577 00:27:11,830 --> 00:27:14,360 for one or the other, I want to randomize this 578 00:27:14,360 --> 00:27:18,580 so that there's no chance that I favor one section or the other. 579 00:27:18,580 --> 00:27:19,780 So are you done with that? 580 00:27:19,780 --> 00:27:20,530 You shuffled them. 581 00:27:20,530 --> 00:27:21,610 You don't know which is which. 582 00:27:21,610 --> 00:27:23,818 OK, I'd like you to take these two face down, and put 583 00:27:23,818 --> 00:27:25,990 one in front of one of these packages, 584 00:27:25,990 --> 00:27:29,800 and the other in front of the other face down as well. 585 00:27:29,800 --> 00:27:33,169 While you do that, can you go ahead and flip your coin? 586 00:27:33,169 --> 00:27:34,710 And as soon as he puts that on there, 587 00:27:34,710 --> 00:27:37,320 I want you to tell me whether you flipped heads or tails. 588 00:27:37,320 --> 00:27:40,140 And based upon that, the particular object 589 00:27:40,140 --> 00:27:44,940 that is chosen will be auctioned off in this particular section. 590 00:27:44,940 --> 00:27:45,540 OK, go ahead. 591 00:27:45,540 --> 00:27:46,754 What have you got? 592 00:27:46,754 --> 00:27:47,420 AUDIENCE: Tails. 593 00:27:47,420 --> 00:27:48,630 ANDREW W. LO: Tails, OK. 594 00:27:48,630 --> 00:27:50,310 So tails. 595 00:27:50,310 --> 00:27:53,850 This is heads, and this is tails. 596 00:27:53,850 --> 00:27:56,647 So here is the item that I'm going to auction off. 597 00:27:56,647 --> 00:27:58,480 Before I do that, I'm going to ask somebody. 598 00:27:58,480 --> 00:28:01,760 Anybody know what's in here? 599 00:28:01,760 --> 00:28:03,290 Nobody knows what's in that box? 600 00:28:05,549 --> 00:28:07,090 Well, what do you think its value is? 601 00:28:09,750 --> 00:28:12,550 Zero? 602 00:28:12,550 --> 00:28:15,049 Negative? 603 00:28:15,049 --> 00:28:16,090 Can't be negative, right? 604 00:28:16,090 --> 00:28:17,630 There's limited liabilities. 605 00:28:17,630 --> 00:28:20,500 You can't owe me for something that's in there. 606 00:28:20,500 --> 00:28:21,250 So good. 607 00:28:21,250 --> 00:28:22,750 We've established some information. 608 00:28:22,750 --> 00:28:25,210 There's a zero lower bound. 609 00:28:25,210 --> 00:28:28,634 Well, I don't know what the value is. 610 00:28:28,634 --> 00:28:31,050 So what we're going to do is we're going to figure it out. 611 00:28:31,050 --> 00:28:35,130 Rather, you're going to figure it out. 612 00:28:35,130 --> 00:28:38,210 I'm going to auction this off, and now this is for real. 613 00:28:38,210 --> 00:28:44,690 So don't bid if you can't pay me, and by the way, 614 00:28:44,690 --> 00:28:47,810 I expect to be paid in cash. 615 00:28:47,810 --> 00:28:49,100 All right? 616 00:28:49,100 --> 00:28:50,280 So I'm serious. 617 00:28:50,280 --> 00:28:51,650 This is a serious game. 618 00:28:51,650 --> 00:28:53,150 So if you don't want to participate, 619 00:28:53,150 --> 00:28:55,280 you're not prepared to pay me in cash at the end 620 00:28:55,280 --> 00:28:57,320 of this lecture, do not bid. 621 00:28:57,320 --> 00:28:58,970 All right? 622 00:28:58,970 --> 00:29:01,370 OK, I'm going to open it up. 623 00:29:01,370 --> 00:29:04,204 Anybody want to start bidding for this item? 624 00:29:04,204 --> 00:29:04,970 AUDIENCE: $1. 625 00:29:04,970 --> 00:29:06,310 ANDREW W. LO: $1. 626 00:29:06,310 --> 00:29:07,230 AUDIENCE: Three. 627 00:29:07,230 --> 00:29:08,766 ANDREW W. LO: $3. 628 00:29:08,766 --> 00:29:09,662 AUDIENCE: $4. 629 00:29:09,662 --> 00:29:10,427 AUDIENCE: Four. 630 00:29:10,427 --> 00:29:11,010 AUDIENCE: Six. 631 00:29:11,010 --> 00:29:12,185 ANDREW W. LO: Six. 632 00:29:12,185 --> 00:29:12,810 AUDIENCE: Five. 633 00:29:12,810 --> 00:29:15,650 ANDREW W. LO: All right, $6 is the high bid. 634 00:29:15,650 --> 00:29:17,650 Can't do that. 635 00:29:17,650 --> 00:29:20,250 All right, $6 is the high bid. 636 00:29:20,250 --> 00:29:21,547 AUDIENCE: Ten. 637 00:29:21,547 --> 00:29:22,130 AUDIENCE: Ten. 638 00:29:22,130 --> 00:29:22,879 ANDREW W. LO: Ten. 639 00:29:22,879 --> 00:29:23,940 OK, we got two tens here. 640 00:29:23,940 --> 00:29:24,731 You were the first. 641 00:29:24,731 --> 00:29:25,650 So that's your bid. 642 00:29:25,650 --> 00:29:27,834 Your bid is the high bid. $10. 643 00:29:27,834 --> 00:29:28,640 AUDIENCE: 20. 644 00:29:28,640 --> 00:29:29,390 ANDREW W. LO: 20. 645 00:29:29,390 --> 00:29:30,490 We have 20. 646 00:29:30,490 --> 00:29:31,034 Wow! 647 00:29:31,034 --> 00:29:31,950 AUDIENCE: High roller. 648 00:29:31,950 --> 00:29:33,120 ANDREW W. LO: $20. 649 00:29:33,120 --> 00:29:36,120 You do see that this package is smaller than this one, right? 650 00:29:36,120 --> 00:29:38,250 It's a tiny little thing. $20. 651 00:29:38,250 --> 00:29:39,030 AUDIENCE: 30. 652 00:29:39,030 --> 00:29:41,610 ANDREW W. LO: $30. 653 00:29:41,610 --> 00:29:43,680 $30. 654 00:29:43,680 --> 00:29:45,280 High bid. 655 00:29:45,280 --> 00:29:46,986 Any more than $30? 656 00:29:46,986 --> 00:29:48,690 AUDIENCE: Can I ask a question, please? 657 00:29:48,690 --> 00:29:49,934 ANDREW W. LO: Yes. 658 00:29:49,934 --> 00:29:51,260 AUDIENCE: Where does the money-- who gets it? 659 00:29:51,260 --> 00:29:52,510 ANDREW W. LO: I get the money. 660 00:29:52,510 --> 00:29:53,820 That's a great question. 661 00:29:53,820 --> 00:29:55,020 That's a great question. 662 00:29:55,020 --> 00:29:56,720 This is going to go to the foundation 663 00:29:56,720 --> 00:29:59,810 to support Andrew Lo. 664 00:29:59,810 --> 00:30:00,680 I'm the charity. 665 00:30:00,680 --> 00:30:02,930 So this is not a charity auction. 666 00:30:02,930 --> 00:30:04,700 This is going to go to me. 667 00:30:04,700 --> 00:30:06,860 By the way, I paid for these items. 668 00:30:06,860 --> 00:30:10,054 So that's why it's going to go to reimburse my teaching costs. 669 00:30:10,054 --> 00:30:11,970 AUDIENCE: It's going to ice cream, [INAUDIBLE] 670 00:30:11,970 --> 00:30:12,890 ANDREW W. LO: Right. 671 00:30:12,890 --> 00:30:15,040 OK, $30 high bid. 672 00:30:15,040 --> 00:30:18,790 Any higher bid than that? 673 00:30:18,790 --> 00:30:20,190 $30? 674 00:30:20,190 --> 00:30:20,910 Nothing higher? 675 00:30:20,910 --> 00:30:21,802 AUDIENCE: 31. 676 00:30:21,802 --> 00:30:22,510 ANDREW W. LO: 31. 677 00:30:25,940 --> 00:30:26,920 AUDIENCE: 35. 678 00:30:26,920 --> 00:30:29,340 ANDREW W. LO: 35. 679 00:30:29,340 --> 00:30:32,500 OK, do I hear 40? 680 00:30:32,500 --> 00:30:35,910 Anybody want to do 40? 681 00:30:35,910 --> 00:30:37,525 $40? 682 00:30:37,525 --> 00:30:38,650 AUDIENCE: I'll give you 40. 683 00:30:38,650 --> 00:30:38,980 ANDREW W. LO: $40. 684 00:30:38,980 --> 00:30:40,135 All right, we've got $40. 685 00:30:43,480 --> 00:30:47,267 Anybody willing to go 45? 686 00:30:47,267 --> 00:30:47,766 $45? 687 00:30:51,060 --> 00:30:51,929 All right. 688 00:30:51,929 --> 00:30:52,470 AUDIENCE: 45. 689 00:30:52,470 --> 00:30:54,360 ANDREW W. LO: $45. 690 00:30:54,360 --> 00:30:55,950 Wow! 691 00:30:55,950 --> 00:30:56,850 OK. 692 00:30:56,850 --> 00:30:59,085 Do we hear 50? 693 00:30:59,085 --> 00:30:59,585 $50? 694 00:31:02,120 --> 00:31:03,720 45 is the high bid. 695 00:31:03,720 --> 00:31:05,507 Anybody for 50? 696 00:31:05,507 --> 00:31:06,590 AUDIENCE: Can I short too? 697 00:31:06,590 --> 00:31:08,790 ANDREW W. LO: No shorting, sorry. 698 00:31:08,790 --> 00:31:10,770 I'm the only auctioneer here. 699 00:31:10,770 --> 00:31:13,290 $45 is the high bid. 700 00:31:13,290 --> 00:31:14,220 Anybody here 50? 701 00:31:14,220 --> 00:31:15,930 Going once. 702 00:31:15,930 --> 00:31:18,040 Going twice. 703 00:31:18,040 --> 00:31:20,404 All right, sold. $45. 704 00:31:20,404 --> 00:31:21,820 Now you're going to pay me, right? 705 00:31:21,820 --> 00:31:22,403 AUDIENCE: Yep. 706 00:31:22,403 --> 00:31:24,130 ANDREW W. LO: All right. 707 00:31:24,130 --> 00:31:28,080 We established the value. 708 00:31:28,080 --> 00:31:31,110 It's $45. 709 00:31:31,110 --> 00:31:33,900 That's the market at work. 710 00:31:33,900 --> 00:31:35,820 None of you knew what was in here. 711 00:31:35,820 --> 00:31:37,830 It could be nothing actually. 712 00:31:40,680 --> 00:31:45,810 But I suspect that you didn't think it was nothing, 713 00:31:45,810 --> 00:31:47,760 because you bid for it, right? 714 00:31:47,760 --> 00:31:50,100 Moreover, I didn't let you touch it. 715 00:31:50,100 --> 00:31:51,150 I didn't let you feel it. 716 00:31:51,150 --> 00:31:52,080 I didn't let you shake it. 717 00:31:52,080 --> 00:31:53,788 There was no information whatsoever other 718 00:31:53,788 --> 00:31:56,040 this very pretty packaging. 719 00:31:56,040 --> 00:31:59,370 And yet somehow magically you were 720 00:31:59,370 --> 00:32:01,080 able to come up with a value. 721 00:32:01,080 --> 00:32:04,550 Now we could argue whether that value is good or bad. 722 00:32:04,550 --> 00:32:06,920 But it's a number, and it's a number that 723 00:32:06,920 --> 00:32:10,160 can now be used for analysis. 724 00:32:10,160 --> 00:32:13,041 Now again, I'm not commenting on how good or bad the number is. 725 00:32:13,041 --> 00:32:14,540 In a minute we're going to find out, 726 00:32:14,540 --> 00:32:15,831 because I'm going to open this. 727 00:32:15,831 --> 00:32:19,790 Or let this gentleman here open it, and see what he bought. 728 00:32:19,790 --> 00:32:24,860 But before he does that, I want to comment that knowing nothing 729 00:32:24,860 --> 00:32:29,220 without any information whatsoever, 730 00:32:29,220 --> 00:32:31,910 we've established value. 731 00:32:31,910 --> 00:32:32,960 That's remarkable. 732 00:32:32,960 --> 00:32:36,500 Now it's not true, though, that there is no information. 733 00:32:36,500 --> 00:32:39,310 In fact, there's a tremendous amount 734 00:32:39,310 --> 00:32:41,260 of information in this room. 735 00:32:41,260 --> 00:32:42,820 Tremendous amount. 736 00:32:42,820 --> 00:32:45,160 Because you know a number of things. 737 00:32:45,160 --> 00:32:47,320 You know about the size of packages. 738 00:32:47,320 --> 00:32:49,600 You know about the fact that I'm a professor, 739 00:32:49,600 --> 00:32:52,960 and if I really cheat you then I might get in trouble 740 00:32:52,960 --> 00:32:54,190 with the dean. 741 00:32:54,190 --> 00:32:58,450 There are a number of constraints that are in place, 742 00:32:58,450 --> 00:33:03,730 and with this audience those constraints affected the value. 743 00:33:03,730 --> 00:33:07,300 For the next five weeks that's what we're going to be doing, 744 00:33:07,300 --> 00:33:09,820 is talking about valuation and trying 745 00:33:09,820 --> 00:33:15,190 to understand how what just happened happened. 746 00:33:15,190 --> 00:33:17,380 OK, would you like to open it up, and let us know 747 00:33:17,380 --> 00:33:20,182 what you've got for your $45? 748 00:33:20,182 --> 00:33:21,640 And you'll let me know whether this 749 00:33:21,640 --> 00:33:25,450 has been a good deal or a bad deal for you and for me. 750 00:33:30,624 --> 00:33:31,290 Oh, just rip it. 751 00:33:34,499 --> 00:33:35,790 My wife does this all the time. 752 00:33:35,790 --> 00:33:37,790 It drives me crazy. 753 00:33:37,790 --> 00:33:39,280 My sons are just-- 754 00:33:39,280 --> 00:33:42,949 AUDIENCE: I'm enjoying my [INAUDIBLE] $45. 755 00:33:42,949 --> 00:33:43,990 ANDREW W. LO: Fair point. 756 00:33:43,990 --> 00:33:44,670 Fair point. 757 00:33:51,118 --> 00:33:52,606 AUDIENCE: Oohhh! 758 00:33:52,606 --> 00:33:56,078 [APPLAUSE] 759 00:33:58,951 --> 00:34:01,450 ANDREW W. LO: Anybody know what the retail value of that is? 760 00:34:01,450 --> 00:34:05,276 It's an iPod Nano 4 gig version. 761 00:34:05,276 --> 00:34:06,730 AUDIENCE: 125. 762 00:34:06,730 --> 00:34:10,159 ANDREW W. LO: 149 to be precise. 763 00:34:10,159 --> 00:34:11,620 So you had a good deal. 764 00:34:11,620 --> 00:34:12,620 AUDIENCE: Yeah, yeah. 765 00:34:12,620 --> 00:34:13,120 Thank you. 766 00:34:13,120 --> 00:34:14,679 ANDREW W. LO: You're welcome. 767 00:34:14,679 --> 00:34:18,330 Thank you, because what we did was 768 00:34:18,330 --> 00:34:20,340 to engage in a price discovery process 769 00:34:20,340 --> 00:34:21,929 with limited information. 770 00:34:21,929 --> 00:34:23,820 With limited information. 771 00:34:23,820 --> 00:34:27,210 I couldn't get the value out of that that I wanted to. 772 00:34:27,210 --> 00:34:31,639 I would have loved to have gotten a bid of $149, 773 00:34:31,639 --> 00:34:34,730 but would any of you be willing to pay that for a box 774 00:34:34,730 --> 00:34:37,310 with no information at all? 775 00:34:37,310 --> 00:34:38,510 Probably not. 776 00:34:38,510 --> 00:34:41,389 So the lack of transparency, the lack of information, 777 00:34:41,389 --> 00:34:44,460 actually reduced the value of that object. 778 00:34:44,460 --> 00:34:46,190 But nevertheless, it did have a value. 779 00:34:46,190 --> 00:34:48,620 Because some of you were willing to take a chance 780 00:34:48,620 --> 00:34:52,860 that there might be something interesting in that package. 781 00:34:52,860 --> 00:34:56,639 That is what we're going to try to understand over the next 13 782 00:34:56,639 --> 00:34:59,460 weeks, and for the first five of those weeks 783 00:34:59,460 --> 00:35:01,000 we're going to try to take it apart. 784 00:35:01,000 --> 00:35:04,800 We're going to try to understand how it is that the market comes 785 00:35:04,800 --> 00:35:08,130 up with the value. 786 00:35:08,130 --> 00:35:09,850 And it's going to be a challenge. 787 00:35:09,850 --> 00:35:12,180 This is hard to do, because just like 788 00:35:12,180 --> 00:35:14,970 if we decided to spend the rest of the lecture figuring out 789 00:35:14,970 --> 00:35:17,820 how you came up with a $45 bid, or why you 790 00:35:17,820 --> 00:35:20,670 weren't willing to go to 50. 791 00:35:20,670 --> 00:35:23,220 It's going to be really hard for us to tease out 792 00:35:23,220 --> 00:35:25,990 all of the thinking that went into this kind of discussion. 793 00:35:25,990 --> 00:35:28,450 So that's why we have work to do. 794 00:35:28,450 --> 00:35:30,900 It will be exciting work, because at the end 795 00:35:30,900 --> 00:35:35,850 we are going to come up with specific quantitative analysis 796 00:35:35,850 --> 00:35:39,720 that will tell us how valuation is done. 797 00:35:39,720 --> 00:35:41,460 So that's where we're going to focus on 798 00:35:41,460 --> 00:35:45,630 for the next few weeks. 799 00:35:45,630 --> 00:35:48,870 Clearly once we figure out valuation, 800 00:35:48,870 --> 00:35:50,730 we can then focus on management. 801 00:35:50,730 --> 00:35:53,580 And the first two-thirds of this class 802 00:35:53,580 --> 00:35:55,920 will be focused on valuation. 803 00:35:55,920 --> 00:36:00,150 The last one third will be focused on taking those ideas, 804 00:36:00,150 --> 00:36:04,920 and applying them to management contexts like capital budgeting 805 00:36:04,920 --> 00:36:07,870 and risk management. 806 00:36:07,870 --> 00:36:10,270 For valuation, the kind of questions 807 00:36:10,270 --> 00:36:12,940 that we're going to tackle are ones that implicitly we 808 00:36:12,940 --> 00:36:14,860 did in just a few minutes here. 809 00:36:14,860 --> 00:36:19,030 It's going to be how are financial assets valued 810 00:36:19,030 --> 00:36:22,520 versus how should they be valued, 811 00:36:22,520 --> 00:36:25,190 and is that always the same? 812 00:36:25,190 --> 00:36:27,140 Is it the case that financial assets 813 00:36:27,140 --> 00:36:29,600 are valued the way they should be valued, 814 00:36:29,600 --> 00:36:32,960 and what do we even mean by whether or not it should 815 00:36:32,960 --> 00:36:35,730 be valued in a way or not. 816 00:36:35,730 --> 00:36:38,870 And finally, we're going to ask the question for valuation, 817 00:36:38,870 --> 00:36:41,660 how well do financial markets really work? 818 00:36:41,660 --> 00:36:44,186 Can we always rely on them to work well? 819 00:36:44,186 --> 00:36:45,560 In this case, I don't know if you 820 00:36:45,560 --> 00:36:48,980 would call this particular auction 821 00:36:48,980 --> 00:36:50,594 one that worked out well. 822 00:36:50,594 --> 00:36:52,010 Certainly worked out well for you, 823 00:36:52,010 --> 00:36:54,630 but it didn't work out well for me. 824 00:36:54,630 --> 00:36:58,250 So in what sense did it work out well? 825 00:36:58,250 --> 00:37:00,050 Well, it worked out well in the sense 826 00:37:00,050 --> 00:37:02,090 that if I really wanted to get rid of that box, 827 00:37:02,090 --> 00:37:06,396 if I really wanted to unload it, I actually was able to do that. 828 00:37:06,396 --> 00:37:07,520 And I got something for it. 829 00:37:07,520 --> 00:37:10,040 Sight unseen, with no information whatsoever, 830 00:37:10,040 --> 00:37:12,050 I actually got $45. 831 00:37:12,050 --> 00:37:14,090 Roughly a third of the value of the asset. 832 00:37:14,090 --> 00:37:16,490 That's actually not too bad. 833 00:37:16,490 --> 00:37:20,460 If you're trying to sell an asset sight unseen, 834 00:37:20,460 --> 00:37:23,130 and you need to do it immediately, 835 00:37:23,130 --> 00:37:27,617 a 66% discount is actually pretty fair. 836 00:37:27,617 --> 00:37:29,450 Now we're going to see more examples of that 837 00:37:29,450 --> 00:37:31,430 over the next few weeks. 838 00:37:31,430 --> 00:37:35,180 Once we determine value, then the question is management. 839 00:37:35,180 --> 00:37:36,890 How much should I save or spend? 840 00:37:36,890 --> 00:37:39,200 That's a management question that all of you 841 00:37:39,200 --> 00:37:42,110 have to deal with at some point or another in your lives. 842 00:37:42,110 --> 00:37:42,890 What should I buy? 843 00:37:42,890 --> 00:37:44,180 What should I sell? 844 00:37:44,180 --> 00:37:46,220 When should I buy and sell it, and how should I 845 00:37:46,220 --> 00:37:47,840 finance the transaction? 846 00:37:47,840 --> 00:37:50,330 Those are the problems of financial analysis 847 00:37:50,330 --> 00:37:51,800 plain and simple. 848 00:37:51,800 --> 00:37:55,190 These are problems that apply to Jack Welch, to James Simons, 849 00:37:55,190 --> 00:37:56,990 to Warren Buffett, and to you. 850 00:37:56,990 --> 00:38:01,040 And it applies to you not just from the corporate perspective, 851 00:38:01,040 --> 00:38:02,780 but from a personal perspective as well. 852 00:38:02,780 --> 00:38:05,780 Every one of you have to think about these issues 853 00:38:05,780 --> 00:38:07,650 on a daily basis. 854 00:38:07,650 --> 00:38:11,510 And so finance really is completely 855 00:38:11,510 --> 00:38:14,450 inclusive in the sense that it applies to virtually everything 856 00:38:14,450 --> 00:38:18,600 that you will ever encounter in life. 857 00:38:18,600 --> 00:38:20,350 To do that I have to go over the framework 858 00:38:20,350 --> 00:38:25,610 of financial analysis, and the starting point is accounting. 859 00:38:25,610 --> 00:38:31,540 Accounting is the language, the lexicon of finance 860 00:38:31,540 --> 00:38:33,670 in that it's the beginning of how 861 00:38:33,670 --> 00:38:35,770 to measure economic concepts. 862 00:38:35,770 --> 00:38:41,230 Like profit and loss, revenues and costs, and so on. 863 00:38:41,230 --> 00:38:44,980 So while many of you may not have accounting backgrounds, 864 00:38:44,980 --> 00:38:48,380 you will learn a fair bit of accounting in this course, 865 00:38:48,380 --> 00:38:50,890 just because you're going to have to in order to understand 866 00:38:50,890 --> 00:38:53,410 the material in the lectures. 867 00:38:53,410 --> 00:38:56,110 So you'll need to get familiar with the basic terms 868 00:38:56,110 --> 00:38:57,940 of accounting, and in particular you're 869 00:38:57,940 --> 00:39:01,870 going to have to focus on two concepts that are probably 870 00:39:01,870 --> 00:39:02,560 alien to you. 871 00:39:02,560 --> 00:39:05,850 The notion of a stock and a flow. 872 00:39:05,850 --> 00:39:09,420 Now when I say stock, I don't mean common stock or equities, 873 00:39:09,420 --> 00:39:11,670 I have a different term in mind. 874 00:39:11,670 --> 00:39:16,290 By stock in this context, I mean the stock of assets. 875 00:39:16,290 --> 00:39:19,290 The level of assets. 876 00:39:19,290 --> 00:39:24,360 And by flow I mean the rate of change of assets. 877 00:39:24,360 --> 00:39:26,380 You know when I was in grad school, 878 00:39:26,380 --> 00:39:28,740 we started discussing this concept on the first day 879 00:39:28,740 --> 00:39:30,745 of macroeconomics, and then one of the students 880 00:39:30,745 --> 00:39:32,870 in the back of the room said, excuse me, Professor, 881 00:39:32,870 --> 00:39:36,600 but isn't that just the distinction between a variable 882 00:39:36,600 --> 00:39:38,750 and its first derivative? 883 00:39:38,750 --> 00:39:42,400 And the professor was a little bit taken aback and said, 884 00:39:42,400 --> 00:39:43,400 well, yes, that's right. 885 00:39:43,400 --> 00:39:45,180 But let me give you another way of thinking about it that 886 00:39:45,180 --> 00:39:46,400 is somewhat more intuitive. 887 00:39:46,400 --> 00:39:48,440 And that is, think about a bathtub, 888 00:39:48,440 --> 00:39:50,840 and think about the faucet turned on 889 00:39:50,840 --> 00:39:53,200 and the water flowing into it. 890 00:39:53,200 --> 00:39:56,770 The stock is the level of the water. 891 00:39:56,770 --> 00:40:01,910 The flow is how fast the water is coming into the tub. 892 00:40:01,910 --> 00:40:04,790 And so after that explanation the student 893 00:40:04,790 --> 00:40:07,160 still seemed confused, and so the professor said, 894 00:40:07,160 --> 00:40:09,364 you know what, some people find bathtubs intuitive, 895 00:40:09,364 --> 00:40:11,030 other people find derivatives intuitive. 896 00:40:11,030 --> 00:40:14,580 So to each his own. 897 00:40:14,580 --> 00:40:16,680 These two concepts are extraordinarily 898 00:40:16,680 --> 00:40:18,720 critical to financial analysis. 899 00:40:18,720 --> 00:40:22,800 And accounting counterparts are nothing more than the balance 900 00:40:22,800 --> 00:40:25,910 sheet and the income statement. 901 00:40:25,910 --> 00:40:29,750 The balance sheet measures the stock of wealth of a company. 902 00:40:29,750 --> 00:40:34,280 What your assets are, and what your claims on those assets 903 00:40:34,280 --> 00:40:37,730 or liabilities are. 904 00:40:37,730 --> 00:40:42,020 On the other hand, the flow of wealth into a company 905 00:40:42,020 --> 00:40:45,980 or out of a company is measured by the income statement. 906 00:40:45,980 --> 00:40:47,810 This tells you how much the company 907 00:40:47,810 --> 00:40:55,630 is making per unit time versus its losses. 908 00:40:55,630 --> 00:40:58,090 So the framework for financial analysis 909 00:40:58,090 --> 00:41:00,400 that we're going to be coming back to time and again 910 00:41:00,400 --> 00:41:02,620 is this framework of a corporation. 911 00:41:02,620 --> 00:41:05,200 A corporation has a certain set of assets. 912 00:41:05,200 --> 00:41:09,110 It's got claims on those assets, which are called liabilities. 913 00:41:09,110 --> 00:41:12,160 So this picture, this snapshot, measures 914 00:41:12,160 --> 00:41:13,960 the level of the bathtub. 915 00:41:13,960 --> 00:41:15,700 But that's not enough to understand 916 00:41:15,700 --> 00:41:18,190 how a company is doing. 917 00:41:18,190 --> 00:41:21,130 You also have to look at the income statement, which 918 00:41:21,130 --> 00:41:25,480 tells you the sources of funds, and the uses of funds 919 00:41:25,480 --> 00:41:26,950 over any time period. 920 00:41:26,950 --> 00:41:30,600 Typically on a quarterly basis. 921 00:41:30,600 --> 00:41:33,680 So we're going to come back to this concept as the framework 922 00:41:33,680 --> 00:41:35,510 for financial analysis. 923 00:41:35,510 --> 00:41:39,950 And by the way, this is the sum total of the tools 924 00:41:39,950 --> 00:41:44,800 that Warren Buffett uses for analyzing his investments. 925 00:41:44,800 --> 00:41:46,010 That's it. 926 00:41:46,010 --> 00:41:47,180 Believe it or not. 927 00:41:47,180 --> 00:41:49,180 Nothing fancier. 928 00:41:49,180 --> 00:41:51,640 So it's an incredibly powerful set of ideas 929 00:41:51,640 --> 00:41:57,370 if you know how to read it. 930 00:41:57,370 --> 00:41:59,380 That framework when you think about it 931 00:41:59,380 --> 00:42:02,440 from a corporate financial decision perspective, 932 00:42:02,440 --> 00:42:08,330 involves making decisions at five points in time. 933 00:42:08,330 --> 00:42:11,540 Corporate financial decisions involve 934 00:42:11,540 --> 00:42:16,470 thinking about how to deal with cash raised from investors. 935 00:42:16,470 --> 00:42:20,680 How to think about cash invested in real assets, 936 00:42:20,680 --> 00:42:24,820 and how to deal with cash generated by operations. 937 00:42:24,820 --> 00:42:28,450 How much cash to reinvest, and how much cash you 938 00:42:28,450 --> 00:42:31,070 give back to your investors. 939 00:42:31,070 --> 00:42:33,610 So from this you should get the idea 940 00:42:33,610 --> 00:42:36,550 that as a corporate financial officer 941 00:42:36,550 --> 00:42:39,610 you are focused on cash, the flow of cash. 942 00:42:39,610 --> 00:42:45,220 In fact, cash you can think of as the lifeblood of a company. 943 00:42:45,220 --> 00:42:47,890 If you follow the cash, you will eventually 944 00:42:47,890 --> 00:42:51,400 hit upon every important aspect of the modern corporation's 945 00:42:51,400 --> 00:42:52,690 operations. 946 00:42:52,690 --> 00:42:54,520 And as a financial officer, you will 947 00:42:54,520 --> 00:42:57,670 be responsible for analyzing that flow. 948 00:42:57,670 --> 00:43:00,400 And as a decision maker, as a leader of a corporation, 949 00:43:00,400 --> 00:43:03,130 you're going to have to make decisions about that cash flow. 950 00:43:03,130 --> 00:43:06,160 Jack Welch uses the information to be 951 00:43:06,160 --> 00:43:07,490 able to make those decisions. 952 00:43:07,490 --> 00:43:10,840 But he doesn't just get those decisions prepackaged for him, 953 00:43:10,840 --> 00:43:13,210 he has to understand what those numbers mean. 954 00:43:13,210 --> 00:43:15,780 Just like Warren Buffett. 955 00:43:15,780 --> 00:43:20,470 Now the corporate financial decisions involved, 956 00:43:20,470 --> 00:43:24,670 obviously, have a variety of different components 957 00:43:24,670 --> 00:43:29,440 from a perspective of career paths. 958 00:43:29,440 --> 00:43:33,160 From the management perspective real investment decisions 959 00:43:33,160 --> 00:43:35,290 involve two and three. 960 00:43:35,290 --> 00:43:37,300 So if you're thinking about investing 961 00:43:37,300 --> 00:43:39,730 in a new division or a new plant or getting 962 00:43:39,730 --> 00:43:41,710 involved in a new product area, you've 963 00:43:41,710 --> 00:43:43,145 got to focus on two and three. 964 00:43:43,145 --> 00:43:45,520 On the other hand, if you're the chief financial officer, 965 00:43:45,520 --> 00:43:47,853 and you're thinking about how should the company finance 966 00:43:47,853 --> 00:43:51,510 its operations, you're going to be focused on one and four. 967 00:43:51,510 --> 00:43:53,230 If you're the board of directors, 968 00:43:53,230 --> 00:43:56,620 and you're deciding how much to pay out to the shareholders, 969 00:43:56,620 --> 00:43:58,470 you're going to be thinking about five. 970 00:43:58,470 --> 00:43:59,890 And if you're engaged in managing 971 00:43:59,890 --> 00:44:01,390 the risks of the corporation, you're 972 00:44:01,390 --> 00:44:03,790 going to be worried about one and five. 973 00:44:03,790 --> 00:44:07,330 And ultimately your objective as a shareholder 974 00:44:07,330 --> 00:44:10,760 and as a manager of this corporation 975 00:44:10,760 --> 00:44:13,070 is to do well by the owners. 976 00:44:13,070 --> 00:44:16,340 So your objective is to maximize shareholder wealth, 977 00:44:16,340 --> 00:44:18,800 and the framework that I've introduced 978 00:44:18,800 --> 00:44:20,750 is going to allow you to do that. 979 00:44:20,750 --> 00:44:23,480 Now again, this may seem kind of theoretical to you, 980 00:44:23,480 --> 00:44:24,380 and I realize that. 981 00:44:24,380 --> 00:44:27,110 So I'm going to ask you to make this more personal. 982 00:44:27,110 --> 00:44:30,020 And to do that, I'm going to ask you to turn this 983 00:44:30,020 --> 00:44:32,690 into your own personal household financial decision 984 00:44:32,690 --> 00:44:34,260 making framework. 985 00:44:34,260 --> 00:44:36,140 So I'd like you to take all of these ideas 986 00:44:36,140 --> 00:44:38,960 and literally apply them to yourself. 987 00:44:38,960 --> 00:44:42,680 Think about the cash flows that are 988 00:44:42,680 --> 00:44:45,050 flowing through your own life. 989 00:44:45,050 --> 00:44:48,320 There may not be that much right now since you're at school, 990 00:44:48,320 --> 00:44:51,500 but believe me, it will grow. 991 00:44:51,500 --> 00:44:55,400 So the household, this is you, sits in 992 00:44:55,400 --> 00:44:57,750 between real economic activities. 993 00:44:57,750 --> 00:45:00,830 In other words, your job, and financial assets 994 00:45:00,830 --> 00:45:04,880 and liabilities, which are all of the financial transactions 995 00:45:04,880 --> 00:45:06,170 that you deal with. 996 00:45:06,170 --> 00:45:11,410 So this cash flow process that I outlined for corporations, it 997 00:45:11,410 --> 00:45:13,360 works for you too. 998 00:45:13,360 --> 00:45:17,350 So there's cash raised from financial institutions, right? 999 00:45:17,350 --> 00:45:22,600 Like student loans or borrowing or home equity loans. 1000 00:45:22,600 --> 00:45:25,100 There's cash invested in real assets. 1001 00:45:25,100 --> 00:45:27,790 What's the biggest real asset that you are all 1002 00:45:27,790 --> 00:45:29,117 investing in right now? 1003 00:45:29,117 --> 00:45:30,450 AUDIENCE: Education [INAUDIBLE]. 1004 00:45:30,450 --> 00:45:31,366 ANDREW W. LO: Exactly. 1005 00:45:31,366 --> 00:45:32,640 Human capital, yourselves. 1006 00:45:32,640 --> 00:45:35,250 Your own education. 1007 00:45:35,250 --> 00:45:37,082 Cash generated by labor supply. 1008 00:45:37,082 --> 00:45:38,540 Well, obviously, when you get a job 1009 00:45:38,540 --> 00:45:40,920 you're going to be generating cash. 1010 00:45:40,920 --> 00:45:43,740 Cash consumed and reinvested in real assets. 1011 00:45:43,740 --> 00:45:47,820 So consumed means beer or pretzels or whatever, 1012 00:45:47,820 --> 00:45:49,500 and investing in real assets means 1013 00:45:49,500 --> 00:45:53,580 you invested either in yourself or you invest it 1014 00:45:53,580 --> 00:45:56,190 in a home or your children. 1015 00:45:56,190 --> 00:45:57,584 Those are real assets. 1016 00:45:57,584 --> 00:45:59,250 Sometimes they're also real liabilities, 1017 00:45:59,250 --> 00:46:00,960 but that's a separate issue. 1018 00:46:00,960 --> 00:46:05,327 And finally cash invested in financial assets. 1019 00:46:05,327 --> 00:46:07,410 Most of you may not have a lot of financial assets 1020 00:46:07,410 --> 00:46:09,870 at this point, but you actually have some. 1021 00:46:09,870 --> 00:46:13,542 I suspect 401(k) plans, retirement, Social Security. 1022 00:46:13,542 --> 00:46:16,000 Those are financial assets that whether you know it or not, 1023 00:46:16,000 --> 00:46:17,490 you're invested in. 1024 00:46:17,490 --> 00:46:20,730 And so when you think about management, 1025 00:46:20,730 --> 00:46:22,740 think about personal management. 1026 00:46:22,740 --> 00:46:25,070 How are you managing yourself? 1027 00:46:25,070 --> 00:46:26,820 You've got to think about real investment. 1028 00:46:26,820 --> 00:46:29,580 Consumption and financing, savings and investment, 1029 00:46:29,580 --> 00:46:32,790 risk management, and, obviously, what is 1030 00:46:32,790 --> 00:46:36,420 your overall objective in life? 1031 00:46:36,420 --> 00:46:40,860 And what you ought to be doing is with that objective in mind, 1032 00:46:40,860 --> 00:46:43,710 managing your real and financial assets 1033 00:46:43,710 --> 00:46:49,680 to maximize the likelihood of achieving those objectives. 1034 00:46:49,680 --> 00:46:52,170 So what I'm asking you to do is, I want you 1035 00:46:52,170 --> 00:46:54,660 to take this course personally. 1036 00:46:54,660 --> 00:46:56,130 I want you to take the ideas. 1037 00:46:56,130 --> 00:46:58,380 Every single idea that I mention, 1038 00:46:58,380 --> 00:47:01,320 and whether I tell you to or not for the next 13 weeks, 1039 00:47:01,320 --> 00:47:04,120 I want you to take that idea and ask the question, 1040 00:47:04,120 --> 00:47:05,790 how does that make my life better off? 1041 00:47:05,790 --> 00:47:11,070 How can I use that in my own personal management activities 1042 00:47:11,070 --> 00:47:13,240 to improve the kind of decisions that I'm making? 1043 00:47:13,240 --> 00:47:15,600 Because if you could do that, if you 1044 00:47:15,600 --> 00:47:17,550 learn how to do that instinctively, 1045 00:47:17,550 --> 00:47:19,470 you will then take those ideas and apply them 1046 00:47:19,470 --> 00:47:21,661 to management contexts in your career. 1047 00:47:21,661 --> 00:47:23,160 And it will make it much more likely 1048 00:47:23,160 --> 00:47:25,170 that you'll get more out of this course 1049 00:47:25,170 --> 00:47:27,820 than you otherwise might. 1050 00:47:27,820 --> 00:47:29,920 Now there are two other factors that I describe 1051 00:47:29,920 --> 00:47:33,520 that make financial analysis challenging, 1052 00:47:33,520 --> 00:47:40,970 and those two factors are time and risk. 1053 00:47:40,970 --> 00:47:43,910 I've argued before that without these two elements 1054 00:47:43,910 --> 00:47:45,440 finance is complete. 1055 00:47:45,440 --> 00:47:47,600 There is no more research to be done. 1056 00:47:47,600 --> 00:47:50,810 There's no more analysis to be done, and all of you 1057 00:47:50,810 --> 00:47:55,520 probably will already be able to intuit a lot of the decisions 1058 00:47:55,520 --> 00:47:58,130 that you're going to be forced to make. 1059 00:47:58,130 --> 00:48:02,210 Because without time-- and by time I mean decisions 1060 00:48:02,210 --> 00:48:04,380 at different points in time-- 1061 00:48:04,380 --> 00:48:10,620 without time and without risk financial decisions 1062 00:48:10,620 --> 00:48:14,250 actually reduce to basic micro economic analysis. 1063 00:48:14,250 --> 00:48:17,130 If you've taken an undergraduate course in microeconomics 1064 00:48:17,130 --> 00:48:19,230 supply equal demand, well, you've 1065 00:48:19,230 --> 00:48:22,110 learned all there is to learn about finance without time 1066 00:48:22,110 --> 00:48:24,210 and risk. 1067 00:48:24,210 --> 00:48:27,510 The only reason that finance is interesting, 1068 00:48:27,510 --> 00:48:31,460 the only challenging aspects of what we do 1069 00:48:31,460 --> 00:48:35,230 are because of time and risk. 1070 00:48:35,230 --> 00:48:39,220 The fact that cash flows now are not the same as cash 1071 00:48:39,220 --> 00:48:44,550 flows later, and that time flows in only one direction. 1072 00:48:44,550 --> 00:48:47,020 In about four lectures, I'm going 1073 00:48:47,020 --> 00:48:49,390 to give you an alternative proof of the theory 1074 00:48:49,390 --> 00:48:51,720 of special relativity. 1075 00:48:51,720 --> 00:48:54,050 And this proof will have to do with the fact 1076 00:48:54,050 --> 00:48:57,020 that interest rates are not negative. 1077 00:48:57,020 --> 00:48:59,900 It turns out that there's a very deep philosophical connection 1078 00:48:59,900 --> 00:49:03,022 between finance and physics that we're going to get to. 1079 00:49:03,022 --> 00:49:05,480 But this is something that you don't need to be a physicist 1080 00:49:05,480 --> 00:49:06,270 to understand. 1081 00:49:06,270 --> 00:49:08,570 In fact, I'd argue that Warren Buffett, 1082 00:49:08,570 --> 00:49:13,270 although he may not be able to articulate these principles, 1083 00:49:13,270 --> 00:49:15,750 these are principles that are somehow 1084 00:49:15,750 --> 00:49:18,090 inbred in his worldview. 1085 00:49:18,090 --> 00:49:22,410 He knows that $1 today is not the same as $1 next year. 1086 00:49:22,410 --> 00:49:24,870 And he also knows that $1 today without risk 1087 00:49:24,870 --> 00:49:27,810 is not the same as $1 today with a little bit of risk. 1088 00:49:27,810 --> 00:49:31,440 Even a tiny little bit of risk, he knows that. 1089 00:49:31,440 --> 00:49:35,220 And at the end of this course, you will too. 1090 00:49:35,220 --> 00:49:38,640 So risk we have to talk about in a much more serious way. 1091 00:49:38,640 --> 00:49:41,670 We're not going to get to that for probably six weeks, 1092 00:49:41,670 --> 00:49:46,170 because that's going to take a whole different set of tools 1093 00:49:46,170 --> 00:49:47,460 to understand. 1094 00:49:47,460 --> 00:49:50,340 So what I'd like to do for the first three or four weeks 1095 00:49:50,340 --> 00:49:55,080 is to focus on time and just time, 1096 00:49:55,080 --> 00:49:57,630 and then I'm going to bring in risk once we develop 1097 00:49:57,630 --> 00:50:02,000 a little bit more machinery to understand how to capture risk. 1098 00:50:02,000 --> 00:50:04,700 And when we put these two together, 1099 00:50:04,700 --> 00:50:07,730 we're going to get modern finance. 1100 00:50:07,730 --> 00:50:13,220 So that will happen some time in week six, seven, and eight. 1101 00:50:13,220 --> 00:50:15,560 Now finally, I want to talk about 1102 00:50:15,560 --> 00:50:17,480 the fundamental principles of finance, 1103 00:50:17,480 --> 00:50:21,860 and then I'm going to talk specifically about this course. 1104 00:50:21,860 --> 00:50:27,440 There are six fundamental ideas that finance has come up 1105 00:50:27,440 --> 00:50:32,660 with that really will change the way you think about the world, 1106 00:50:32,660 --> 00:50:35,360 and you won't appreciate it today. 1107 00:50:35,360 --> 00:50:36,710 I know that. 1108 00:50:36,710 --> 00:50:40,430 But I want to put it into your subconscious today, 1109 00:50:40,430 --> 00:50:44,000 because sometime over the next 13 weeks, 1110 00:50:44,000 --> 00:50:49,220 at least I hope over the next 13 weeks, your face will light up 1111 00:50:49,220 --> 00:50:50,972 and you're going to get it one day. 1112 00:50:50,972 --> 00:50:52,430 You're going to get it in the sense 1113 00:50:52,430 --> 00:50:54,890 that you will understand at that point in time 1114 00:50:54,890 --> 00:50:58,590 how these six principles can be used 1115 00:50:58,590 --> 00:51:02,160 to make any financial decision that you need to make 1116 00:51:02,160 --> 00:51:04,020 for the rest of your careers. 1117 00:51:04,020 --> 00:51:06,310 The first principle is pretty obvious. 1118 00:51:06,310 --> 00:51:09,030 There is no such thing as a free lunch. 1119 00:51:09,030 --> 00:51:11,790 Actually all of these principles are 1120 00:51:11,790 --> 00:51:14,950 approximations to a much more complex truth. 1121 00:51:14,950 --> 00:51:17,370 So if you really want to be strict about it, 1122 00:51:17,370 --> 00:51:20,430 it should read, there may be free lunches on occasion, 1123 00:51:20,430 --> 00:51:24,470 but there's no such thing as a free lunch program. 1124 00:51:24,470 --> 00:51:28,149 There isn't systematic free lunches. 1125 00:51:28,149 --> 00:51:30,440 You might be able to find one or two every now and then 1126 00:51:30,440 --> 00:51:33,280 if you're lucky and if you work hard, 1127 00:51:33,280 --> 00:51:38,530 but systematic transfers of wealth for no reason at all 1128 00:51:38,530 --> 00:51:41,270 are unlikely. 1129 00:51:41,270 --> 00:51:42,980 Second principle. 1130 00:51:42,980 --> 00:51:44,840 Other things equal-- and this is a phrase 1131 00:51:44,840 --> 00:51:47,417 that you'll hear economists utter all the time. 1132 00:51:47,417 --> 00:51:49,250 And of course, other things are never equal, 1133 00:51:49,250 --> 00:51:52,280 but let's pretend that they are. 1134 00:51:52,280 --> 00:51:58,520 Other things equal, individuals satisfy three characteristics. 1135 00:51:58,520 --> 00:52:01,490 They prefer more money to less. 1136 00:52:01,490 --> 00:52:05,250 That's often called non-satiation. 1137 00:52:05,250 --> 00:52:08,250 They prefer money now to money later, 1138 00:52:08,250 --> 00:52:12,840 and they prefer less risk to more risk 1139 00:52:12,840 --> 00:52:16,400 when risk is defined properly. 1140 00:52:16,400 --> 00:52:18,130 Now I'd argue that these principles 1141 00:52:18,130 --> 00:52:21,070 are in fact fairly universal. 1142 00:52:21,070 --> 00:52:24,130 Not that you can't find exceptions every now and then 1143 00:52:24,130 --> 00:52:29,590 for every individual, but by and large over periods of time 1144 00:52:29,590 --> 00:52:33,820 and over a large population this is generally true. 1145 00:52:33,820 --> 00:52:35,590 And if you don't believe me or if you 1146 00:52:35,590 --> 00:52:39,170 know people that don't satisfy these principles, 1147 00:52:39,170 --> 00:52:41,420 please introduce them to me after class. 1148 00:52:41,420 --> 00:52:44,240 I'd like to get to know them, and do some business with them. 1149 00:52:48,270 --> 00:52:49,830 Principle three. 1150 00:52:49,830 --> 00:52:54,400 All agents act to further their own self-interest. 1151 00:52:54,400 --> 00:52:57,610 Now again, this is not to say that there aren't 1152 00:52:57,610 --> 00:52:59,530 Mother Teresas out there. 1153 00:52:59,530 --> 00:53:02,350 That there aren't people that care about the general welfare 1154 00:53:02,350 --> 00:53:04,120 of the public. 1155 00:53:04,120 --> 00:53:07,990 But economists in their own unique and annoying way 1156 00:53:07,990 --> 00:53:12,250 have been able to redefine preferences to even argue 1157 00:53:12,250 --> 00:53:16,630 that Mother Teresa is incredibly selfish, because her utility 1158 00:53:16,630 --> 00:53:19,540 function is the function-- the utility 1159 00:53:19,540 --> 00:53:21,200 function of other people. 1160 00:53:21,200 --> 00:53:23,290 And so by doing all this good, Mother Teresa 1161 00:53:23,290 --> 00:53:26,260 was only furthering her own self-interests. 1162 00:53:26,260 --> 00:53:28,650 Isn't she so selfish. 1163 00:53:28,650 --> 00:53:33,610 Now, so in a way when the economist defines preferences, 1164 00:53:33,610 --> 00:53:36,820 they almost define it as a tautology. 1165 00:53:36,820 --> 00:53:40,660 But finance makes economics practical in the sense 1166 00:53:40,660 --> 00:53:44,830 that I'll describe in a few weeks exactly 1167 00:53:44,830 --> 00:53:48,730 what kinds of preferences are actually embodied in decision 1168 00:53:48,730 --> 00:53:52,730 making, and why this principle is more often than not, 1169 00:53:52,730 --> 00:53:56,830 a pretty good approximation to a much more complex reality. 1170 00:53:56,830 --> 00:54:00,010 Now the last three principles I'm not 1171 00:54:00,010 --> 00:54:03,820 going to talk about in great detail, because those really 1172 00:54:03,820 --> 00:54:06,280 embody a much larger set of issues 1173 00:54:06,280 --> 00:54:07,840 about economics and finance. 1174 00:54:07,840 --> 00:54:10,720 We're going to talk about those three principles, 1175 00:54:10,720 --> 00:54:14,350 but only in the last lecture oddly enough. 1176 00:54:14,350 --> 00:54:15,700 We're going to use them. 1177 00:54:15,700 --> 00:54:17,650 We're going to use these principles, 1178 00:54:17,650 --> 00:54:20,160 but in the last lecture I'm going 1179 00:54:20,160 --> 00:54:24,090 to question all of the framework that I've developed for you, 1180 00:54:24,090 --> 00:54:26,400 and show you where the holes are. 1181 00:54:26,400 --> 00:54:28,140 For the first 13 weeks, I'm going 1182 00:54:28,140 --> 00:54:32,880 to need you to willingly suspend your disbelief as we describe 1183 00:54:32,880 --> 00:54:39,390 the relatively straightforward and standardized framework 1184 00:54:39,390 --> 00:54:41,770 for thinking about financial problems. 1185 00:54:41,770 --> 00:54:43,340 And in the last lecture I'm going 1186 00:54:43,340 --> 00:54:46,530 to describe to you where the approximations were made, 1187 00:54:46,530 --> 00:54:49,860 and why you need to take advanced courses in finance 1188 00:54:49,860 --> 00:54:50,880 to fill those gaps. 1189 00:54:53,520 --> 00:54:57,540 So with that said, let me now turn to course overview, 1190 00:54:57,540 --> 00:55:00,329 and then I'll take questions about course mechanics. 1191 00:55:00,329 --> 00:55:02,370 There are going to be four sections of the course 1192 00:55:02,370 --> 00:55:04,310 as outlined in the syllabus. 1193 00:55:04,310 --> 00:55:07,230 The four sections are the introductory material, 1194 00:55:07,230 --> 00:55:09,420 which we've gone over today. 1195 00:55:09,420 --> 00:55:14,190 Section B, which we will cover for the next three or four 1196 00:55:14,190 --> 00:55:16,830 lectures is valuation. 1197 00:55:16,830 --> 00:55:19,530 Discounting and the mathematics of net present value. 1198 00:55:19,530 --> 00:55:22,410 Pricing stocks, bonds, futures, forwards, and options, 1199 00:55:22,410 --> 00:55:25,530 and the relative kinds of issues that 1200 00:55:25,530 --> 00:55:30,450 come up across those different asset classes. 1201 00:55:30,450 --> 00:55:34,390 Section C will focus on risk, and introduce risk 1202 00:55:34,390 --> 00:55:40,480 into the framework of section B. So once we complete Section C, 1203 00:55:40,480 --> 00:55:44,690 we will then have focused on time and risk. 1204 00:55:44,690 --> 00:55:47,110 And finally section D will be how 1205 00:55:47,110 --> 00:55:51,720 to apply those principles to problems in corporate finance. 1206 00:55:51,720 --> 00:55:57,400 What Jack Welch did from 1981 to 2001. 1207 00:55:57,400 --> 00:55:59,470 How do you take these ideas, and apply them 1208 00:55:59,470 --> 00:56:02,560 to practical circumstances. 1209 00:56:02,560 --> 00:56:04,990 And then the last lecture will be 1210 00:56:04,990 --> 00:56:07,210 a lecture-- this is not the same last lecture 1211 00:56:07,210 --> 00:56:08,470 as other last lectures. 1212 00:56:08,470 --> 00:56:10,742 I'm not going to die, but so I don't mean 1213 00:56:10,742 --> 00:56:11,950 to call it the final lecture. 1214 00:56:11,950 --> 00:56:14,080 That sounds a little ominous. 1215 00:56:14,080 --> 00:56:16,330 The idea behind this last lecture 1216 00:56:16,330 --> 00:56:18,280 is to put it all together, and explain 1217 00:56:18,280 --> 00:56:21,130 how these financial theories interact 1218 00:56:21,130 --> 00:56:24,610 with imperfections in the marketplace, and what is-- 1219 00:56:24,610 --> 00:56:27,070 or is not good approximations. 1220 00:56:29,720 --> 00:56:32,840 Let me talk about course requirements now. 1221 00:56:32,840 --> 00:56:35,900 Obviously the lectures and the readings, 1222 00:56:35,900 --> 00:56:39,320 and attendance and participation will be an important part 1223 00:56:39,320 --> 00:56:40,730 of the course. 1224 00:56:40,730 --> 00:56:44,850 We are not going to cover the entire tome of Brealey, Myers 1225 00:56:44,850 --> 00:56:45,350 and Allen. 1226 00:56:45,350 --> 00:56:48,800 This is a book, which if dropped off of a six-story building 1227 00:56:48,800 --> 00:56:51,020 could actually kill somebody if it hit them. 1228 00:56:51,020 --> 00:56:53,840 So we can't possibly cover the entire textbook. 1229 00:56:53,840 --> 00:56:58,040 We'll cover selected chapters, but this is Finance 401, 1230 00:56:58,040 --> 00:56:59,950 so it's an introductory course. 1231 00:56:59,950 --> 00:57:02,450 And so the readings that you are going to be responsible for 1232 00:57:02,450 --> 00:57:04,575 are the ones that are outlined on the reading list, 1233 00:57:04,575 --> 00:57:07,280 and that I've listed in every lecture. 1234 00:57:07,280 --> 00:57:09,170 So for example, chapters one and two, 1235 00:57:09,170 --> 00:57:11,550 you are now responsible for. 1236 00:57:11,550 --> 00:57:14,470 And we will be grading class participation. 1237 00:57:14,470 --> 00:57:17,430 So I expect you to come to class prepared, and ready 1238 00:57:17,430 --> 00:57:19,560 to discuss material, and possibly 1239 00:57:19,560 --> 00:57:22,170 questions that we may have raised in the previous lecture. 1240 00:57:22,170 --> 00:57:24,650 And there will be one case study that you 1241 00:57:24,650 --> 00:57:27,300 will be responsible for writing up and handing in, 1242 00:57:27,300 --> 00:57:29,430 and that will be worth 10% of the grade. 1243 00:57:29,430 --> 00:57:32,790 And attendance and participation will be worth another 10%. 1244 00:57:32,790 --> 00:57:35,550 So that's 20% of your grade. 1245 00:57:35,550 --> 00:57:39,300 And then finally the midterm and final exam 1246 00:57:39,300 --> 00:57:43,009 will be worth 25% and 55%. 1247 00:57:43,009 --> 00:57:44,550 Let me explain a little bit about how 1248 00:57:44,550 --> 00:57:46,380 the midterm and final exam works, because it's 1249 00:57:46,380 --> 00:57:48,030 a little different in this class than in some 1250 00:57:48,030 --> 00:57:48,904 of the other classes. 1251 00:57:48,904 --> 00:57:51,420 And by the way, this grading scheme 1252 00:57:51,420 --> 00:57:53,430 and the particular mechanisms are 1253 00:57:53,430 --> 00:57:55,680 identical in these two sections that I teach, 1254 00:57:55,680 --> 00:57:58,050 and in the sections that Professor Wang teaches. 1255 00:57:58,050 --> 00:58:01,830 So he and I have coordinated to have the same approach, so 1256 00:58:01,830 --> 00:58:06,560 as not to advantage or disadvantage any one section. 1257 00:58:06,560 --> 00:58:12,510 In your readings packet will be a collection of problems 1258 00:58:12,510 --> 00:58:13,590 that we've put together. 1259 00:58:13,590 --> 00:58:15,120 And actually I don't know if it's in there right now 1260 00:58:15,120 --> 00:58:17,070 or if it's being photocopied, but we 1261 00:58:17,070 --> 00:58:22,800 will prepare a list of problems that you can work on. 1262 00:58:22,800 --> 00:58:24,880 These are completely optional. 1263 00:58:24,880 --> 00:58:27,780 And there are far too many problems for you 1264 00:58:27,780 --> 00:58:32,654 to be able to do even in one full semester. 1265 00:58:32,654 --> 00:58:34,070 The reason we give them to you is, 1266 00:58:34,070 --> 00:58:39,669 because the only way to learn finance is to do finance. 1267 00:58:39,669 --> 00:58:41,210 If you come into the class and listen 1268 00:58:41,210 --> 00:58:44,240 to my lectures you may be entertained 1269 00:58:44,240 --> 00:58:48,270 for an hour and a half, you won't learn the material. 1270 00:58:48,270 --> 00:58:51,110 In fact, I've now changed the way I talk about the course, 1271 00:58:51,110 --> 00:58:56,060 and I don't describe what I do as teaching anymore. 1272 00:58:56,060 --> 00:59:00,260 Because teaching implies that I can force feed knowledge 1273 00:59:00,260 --> 00:59:02,250 into your brains. 1274 00:59:02,250 --> 00:59:04,150 It turns out it can't be done. 1275 00:59:04,150 --> 00:59:08,170 And my two sons have proven that to me time and again. 1276 00:59:08,170 --> 00:59:10,380 You have to want to learn the material, 1277 00:59:10,380 --> 00:59:14,850 so you have to pull the knowledge from me into you. 1278 00:59:14,850 --> 00:59:17,160 In other words, you have to be an active participant. 1279 00:59:17,160 --> 00:59:20,670 My 12th grade math teacher used to say that mathematics 1280 00:59:20,670 --> 00:59:22,500 is not a spectator sport. 1281 00:59:22,500 --> 00:59:23,820 That's the same for finance. 1282 00:59:23,820 --> 00:59:25,740 Finance is not a spectator sport. 1283 00:59:25,740 --> 00:59:27,360 You actually have to do it. 1284 00:59:27,360 --> 00:59:31,080 You have to confront yourself with problems time and again, 1285 00:59:31,080 --> 00:59:33,870 and think about how to apply the principles in our lecture 1286 00:59:33,870 --> 00:59:36,120 to those problems. 1287 00:59:36,120 --> 00:59:39,770 The purpose of a lecture is to give you the motivation, 1288 00:59:39,770 --> 00:59:43,500 and take you through the most difficult aspects 1289 00:59:43,500 --> 00:59:47,220 of the principles and the theories of financial analysis. 1290 00:59:47,220 --> 00:59:50,850 But it's your job to do the analysis. 1291 00:59:50,850 --> 00:59:53,310 And to that end we're going to give you some motivation. 1292 00:59:53,310 --> 00:59:56,370 And the motivation is that the midterm and the final exams 1293 00:59:56,370 --> 00:59:58,530 are structured so that most of the weight 1294 00:59:58,530 --> 00:59:59,970 is placed on the final. 1295 00:59:59,970 --> 01:00:01,840 The reason is the final is cumulative. 1296 01:00:01,840 --> 01:00:04,830 So it's going to cover twice the material as the midterm. 1297 01:00:04,830 --> 01:00:08,160 Therefore it should be worth roughly double. 1298 01:00:08,160 --> 01:00:12,820 But the other reason is that financial analysis 1299 01:00:12,820 --> 01:00:17,630 is alien to the typical human cognitive process. 1300 01:00:17,630 --> 01:00:21,040 None of you are hard wired to engage in net present value 1301 01:00:21,040 --> 01:00:22,660 calculations. 1302 01:00:22,660 --> 01:00:25,450 And so it's going to take some time before you get it, 1303 01:00:25,450 --> 01:00:27,380 before it sinks in. 1304 01:00:27,380 --> 01:00:29,210 And I've taught this class many times 1305 01:00:29,210 --> 01:00:34,750 before, and usually somewhere between week eight and week 13 1306 01:00:34,750 --> 01:00:37,310 a light goes off in your head, and you get it. 1307 01:00:37,310 --> 01:00:39,350 And I see this by the bright smiles 1308 01:00:39,350 --> 01:00:41,070 on your face around that time. 1309 01:00:41,070 --> 01:00:41,750 It could be because you're getting 1310 01:00:41,750 --> 01:00:42,680 to the end of the semester, and you're 1311 01:00:42,680 --> 01:00:44,300 glad to be done with the class. 1312 01:00:44,300 --> 01:00:46,610 But I like to think that it's because at some point 1313 01:00:46,610 --> 01:00:48,380 you actually get it. 1314 01:00:48,380 --> 01:00:50,510 In a few rare cases it happens at week 14, 1315 01:00:50,510 --> 01:00:53,030 which is not so good, but hopefully 1316 01:00:53,030 --> 01:00:55,550 before the final exam. 1317 01:00:55,550 --> 01:00:59,800 Now in order to provide you with extra incentive to do problems, 1318 01:00:59,800 --> 01:01:03,160 and given this is an MBA class, I realize that all of you 1319 01:01:03,160 --> 01:01:04,660 have very busy schedules, and you 1320 01:01:04,660 --> 01:01:07,760 can schedule your own activities better than we can. 1321 01:01:07,760 --> 01:01:10,060 So rather than have weekly problem sets that are due, 1322 01:01:10,060 --> 01:01:12,393 and you have to hand them in, we have to hand them back. 1323 01:01:12,393 --> 01:01:14,000 It's a hassle for everybody. 1324 01:01:14,000 --> 01:01:16,020 There are no problem sets in this class. 1325 01:01:16,020 --> 01:01:17,930 None. 1326 01:01:17,930 --> 01:01:20,820 However, we're going to give you a package of problems 1327 01:01:20,820 --> 01:01:22,740 and solutions upfront. 1328 01:01:22,740 --> 01:01:25,310 You'll get that within the next few days. 1329 01:01:25,310 --> 01:01:31,820 And I will promise you that the majority of exam questions 1330 01:01:31,820 --> 01:01:36,350 will come verbatim from this package of problems. 1331 01:01:36,350 --> 01:01:37,010 Majority. 1332 01:01:37,010 --> 01:01:39,830 Meaning more than 50% of the points 1333 01:01:39,830 --> 01:01:42,020 will come from the package. 1334 01:01:42,020 --> 01:01:47,120 So if all you did was to memorize this entire stack, 1335 01:01:47,120 --> 01:01:49,550 you could ace the course. 1336 01:01:49,550 --> 01:01:51,711 But of course, that would mean you 1337 01:01:51,711 --> 01:01:53,210 would spend enormous amounts of time 1338 01:01:53,210 --> 01:01:57,270 in finance, which is not such a bad outcome either. 1339 01:01:57,270 --> 01:01:59,940 So we want to do this to eliminate 1340 01:01:59,940 --> 01:02:03,166 a lot of the fear and anxiety with financial analysis. 1341 01:02:03,166 --> 01:02:05,040 It is challenging, but it's a lot of fun too. 1342 01:02:05,040 --> 01:02:06,930 We want you to have fun, because that's 1343 01:02:06,930 --> 01:02:09,600 the only way you're going to learn this material well. 1344 01:02:09,600 --> 01:02:13,170 So it's up to you as to how much you want to do. 1345 01:02:13,170 --> 01:02:16,359 The recitations will cover selected problems. 1346 01:02:16,359 --> 01:02:18,150 So you're not going to be left on your own. 1347 01:02:18,150 --> 01:02:21,589 The recitations will go over problems and how to solve them. 1348 01:02:21,589 --> 01:02:23,130 I'll do a few in class, the ones that 1349 01:02:23,130 --> 01:02:25,410 are particularly challenging, but then you'll 1350 01:02:25,410 --> 01:02:26,670 need to do more on your own. 1351 01:02:26,670 --> 01:02:30,300 And if you do that, you will be prepared for the final exam 1352 01:02:30,300 --> 01:02:31,310 better than most. 1353 01:02:31,310 --> 01:02:35,820 The other material will be readings and lecture material, 1354 01:02:35,820 --> 01:02:38,070 and therefore there will be some customization, 1355 01:02:38,070 --> 01:02:40,310 because my lecture style is different from Professor 1356 01:02:40,310 --> 01:02:41,250 Wang's. 1357 01:02:41,250 --> 01:02:43,770 But the majority of the exam will be identical, 1358 01:02:43,770 --> 01:02:48,000 and it will be drawn from these problem banks 1359 01:02:48,000 --> 01:02:51,780 that you're going to get a copy of in advance. 1360 01:02:51,780 --> 01:02:53,940 Now frankly, I have to tell you that I don't really 1361 01:02:53,940 --> 01:02:56,970 like to give grades at all, but I'm forced to do so. 1362 01:02:56,970 --> 01:03:01,110 And so that's why we set up this process for assigning grades. 1363 01:03:01,110 --> 01:03:02,670 In fact, a few years ago, I came up 1364 01:03:02,670 --> 01:03:06,072 with what I thought was a brilliant way to assign grades, 1365 01:03:06,072 --> 01:03:08,280 but I haven't been able to convince the dean's office 1366 01:03:08,280 --> 01:03:09,750 to let me do that. 1367 01:03:09,750 --> 01:03:11,040 And you know what it is? 1368 01:03:11,040 --> 01:03:11,820 It goes like this. 1369 01:03:11,820 --> 01:03:13,620 Let me show you. 1370 01:03:13,620 --> 01:03:21,350 I propose to give everybody in this class a B. That's it. 1371 01:03:21,350 --> 01:03:25,400 Everybody gets a B. Now before I do this, 1372 01:03:25,400 --> 01:03:27,950 how many people would object to that? 1373 01:03:27,950 --> 01:03:29,640 Raise your hand. 1374 01:03:29,640 --> 01:03:32,810 All right, those of you with your hands up, you get As. 1375 01:03:32,810 --> 01:03:33,310 Done. 1376 01:03:36,790 --> 01:03:39,250 You see how brilliant that is? 1377 01:03:39,250 --> 01:03:40,870 I get a grade distribution. 1378 01:03:40,870 --> 01:03:43,330 No work. 1379 01:03:43,330 --> 01:03:46,060 The only problem is it only works once. 1380 01:03:46,060 --> 01:03:47,910 And when you're teaching two sections, so 1381 01:03:47,910 --> 01:03:50,960 somehow the second section, it doesn't work as well. 1382 01:03:50,960 --> 01:03:53,230 So I'm sorry I have to give grades. 1383 01:03:53,230 --> 01:03:54,160 You're all adults. 1384 01:03:54,160 --> 01:03:55,900 I realize that. 1385 01:03:55,900 --> 01:03:57,760 But nevertheless, this is a necessary part 1386 01:03:57,760 --> 01:03:58,510 of the curriculum. 1387 01:03:58,510 --> 01:04:02,590 So that's how we're going to be assigning grades. 1388 01:04:02,590 --> 01:04:05,457 In the last four minutes, and I think 1389 01:04:05,457 --> 01:04:07,790 I'm going to try to keep on time for the entire semester 1390 01:04:07,790 --> 01:04:11,510 so we end at five before the half hour, 1391 01:04:11,510 --> 01:04:13,420 and we start five after the hour. 1392 01:04:13,420 --> 01:04:16,330 In the last four minutes, I want to tell you 1393 01:04:16,330 --> 01:04:19,270 a little bit about how to get the most out of this course. 1394 01:04:19,270 --> 01:04:22,330 And we can take this up next time if you've got questions, 1395 01:04:22,330 --> 01:04:25,700 but I want you to spend time thinking about this. 1396 01:04:25,700 --> 01:04:28,960 Most of this course will be devoted to theory. 1397 01:04:28,960 --> 01:04:31,450 But finance is not a theoretical subject 1398 01:04:31,450 --> 01:04:34,060 unlike algebraic topology. 1399 01:04:34,060 --> 01:04:35,980 That's a theoretical subject. 1400 01:04:35,980 --> 01:04:39,610 I've never heard anybody become a practical or applied 1401 01:04:39,610 --> 01:04:41,530 algebraic topologist. 1402 01:04:41,530 --> 01:04:43,990 Finance on the other hand, there's 1403 01:04:43,990 --> 01:04:46,540 no finance without practice. 1404 01:04:46,540 --> 01:04:49,870 So while the course will be focused on the theory, 1405 01:04:49,870 --> 01:04:52,917 I need you to think about the practical elements of it, 1406 01:04:52,917 --> 01:04:55,250 and I'm going to help you in a couple of different ways. 1407 01:04:55,250 --> 01:04:57,130 One is by problems, but the other 1408 01:04:57,130 --> 01:05:00,670 is to encourage you to sit in on a pro-seminar called 1409 01:05:00,670 --> 01:05:02,882 the Practice of Finance. 1410 01:05:02,882 --> 01:05:04,840 This is a new pro-seminar that we're launching. 1411 01:05:04,840 --> 01:05:07,160 September 17 is the first meeting. 1412 01:05:07,160 --> 01:05:09,687 It doesn't carry any units, so you can come and go 1413 01:05:09,687 --> 01:05:10,270 as you please. 1414 01:05:10,270 --> 01:05:12,670 But it'll give you a sense of the practical aspects 1415 01:05:12,670 --> 01:05:15,340 of the industry, and in particular information 1416 01:05:15,340 --> 01:05:17,170 about the career aspects of the industry 1417 01:05:17,170 --> 01:05:20,380 like what are starting salaries for financial analysts. 1418 01:05:20,380 --> 01:05:22,330 Or how do I get a job in finance if I don't 1419 01:05:22,330 --> 01:05:23,646 have any background in it. 1420 01:05:23,646 --> 01:05:25,270 It'll go through those kinds of issues. 1421 01:05:25,270 --> 01:05:28,370 So I'd encourage you to keep that in mind. 1422 01:05:28,370 --> 01:05:31,870 The second thing is with respect to the course, 1423 01:05:31,870 --> 01:05:34,840 I will give you lecture notes ahead of time 1424 01:05:34,840 --> 01:05:36,670 for all of the lectures. 1425 01:05:36,670 --> 01:05:38,980 I expect you to take a look at them in advance. 1426 01:05:38,980 --> 01:05:39,790 Just skim them. 1427 01:05:39,790 --> 01:05:41,290 You don't have to read them, and try 1428 01:05:41,290 --> 01:05:42,580 to sort out what I'm saying. 1429 01:05:42,580 --> 01:05:44,560 But I want you to skim it at least. 1430 01:05:44,560 --> 01:05:47,230 And then in class I urge you to take lots of notes, 1431 01:05:47,230 --> 01:05:50,410 because the lecture notes are not meant to be complete. 1432 01:05:50,410 --> 01:05:54,070 In fact, they are purposefully incomplete 1433 01:05:54,070 --> 01:05:55,890 so that you have to use your hand 1434 01:05:55,890 --> 01:05:58,570 and write down your impressions of the material 1435 01:05:58,570 --> 01:05:59,920 as I'm speaking. 1436 01:05:59,920 --> 01:06:02,470 Because in that method, you will actually 1437 01:06:02,470 --> 01:06:07,450 absorb more of the material, and it'll stay with you longer. 1438 01:06:07,450 --> 01:06:09,670 I would urge you to review the lectures afterwards. 1439 01:06:09,670 --> 01:06:10,776 Review what I said. 1440 01:06:10,776 --> 01:06:12,400 Because you may have heard what I said, 1441 01:06:12,400 --> 01:06:14,710 but you may not have understood what I said, 1442 01:06:14,710 --> 01:06:17,020 and you may not be able to apply what I said. 1443 01:06:17,020 --> 01:06:21,350 So you need to spend time afterwards soaking it in. 1444 01:06:21,350 --> 01:06:22,940 I urge you to work on the assignments 1445 01:06:22,940 --> 01:06:24,950 in groups, but also alone. 1446 01:06:24,950 --> 01:06:26,970 Because when you do the midterm and final exams, 1447 01:06:26,970 --> 01:06:28,610 you'll be doing them alone. 1448 01:06:28,610 --> 01:06:29,780 So do both. 1449 01:06:29,780 --> 01:06:33,080 Don't just assume that you can do the same in groups 1450 01:06:33,080 --> 01:06:35,240 what you will do alone. 1451 01:06:35,240 --> 01:06:38,732 And finally, I would ask you to ask plenty of questions. 1452 01:06:38,732 --> 01:06:40,440 I'm going to manage the class discussion. 1453 01:06:40,440 --> 01:06:43,670 So that if we have time, I'd be happy to talk about issues that 1454 01:06:43,670 --> 01:06:46,550 are current and on your mind. 1455 01:06:46,550 --> 01:06:50,330 Even whether or not you should refinance your auto loan. 1456 01:06:50,330 --> 01:06:52,520 We're happy to take those kind of questions assuming 1457 01:06:52,520 --> 01:06:55,220 that it's apropos, and that we have the time 1458 01:06:55,220 --> 01:06:56,720 to be able to cover that. 1459 01:06:56,720 --> 01:06:57,950 I want you to get engaged. 1460 01:06:57,950 --> 01:06:59,780 I want you to take this course personally, 1461 01:06:59,780 --> 01:07:01,446 because that's the only way you're going 1462 01:07:01,446 --> 01:07:03,239 to really learn the material. 1463 01:07:03,239 --> 01:07:04,530 All right, thank you very much. 1464 01:07:04,530 --> 01:07:05,280 We're out of time. 1465 01:07:05,280 --> 01:07:07,580 We'll see you next Monday.