MPU 3353

Personal Financial Planning in

Malaysia

Investment Basics:
Understanding Risk and Return

10-1
 Introduction
Risk is a fundamental component of investing.
Risk must be understood and managed.
In selecting securities, it is important to understand
and measure market risk.
Then securities can be selected by choosing securities
with expected returns that exceed required returns.

10-3
 Chapter Objectives
To grasp the nature of risk and its sources and to relate risk to
investment return

To grasp the concepts of required return and expected return

and to see how they are used in security selection

To become familiar with important methods and issues involved

in establishing a portfolio and making changes over time

10-4
 Topic Outline

Risk
Return
Applying a Risk-Return Model (Capital Asset Pricing
Model - CAPM)

10-5
 Risk and Return
What is Risk?
Sources of Risk
How Much Return Do You Need? (CAPM)
The Iron Law of Risk and Return
To earn higher returns, you must take greater risks.
There is a strong positive correlation between higher
investment return and greater risk.

10-6
 What Is Risk?
Investment risk is defined as the more variable an
investments return, the greater its risk.

The more uncertainty associated with the expected

outcome, the greater the risk of the investment.
A highly variable return could lead to investment
losses if the investment must be sold.

The longer the time period before an investment pays

off, the greater the risk.
Investors with long investment horizons /prospects
can handle more risk. 10-7
 Sources of Risk

There are two basic sources of risk:

Changing Economic Conditions
Changing Conditions of the Issuer

10-8
 Changing Economic Conditions

Inflation risk: Will your investment returns keep pace

with inflation? If not, your return may be insufficient.
Business cycle risk: Your investment return fluctuates
in concert with the overall business cycle.
Interest rate risk: Bond prices fluctuate as interest
rates in the economy change. In fact, bond prices
move in the opposite direction of interest rates.

10-9
 Changing Conditions of the Issuer

Management risk: The company you invested in has

poor managers. Some portfolio managers only invest
in companies with good management.
Business risk: Risks associated with the companys
products/service lines
Financial risk: The risk of bankruptcy because the
company has borrowed too much money

10-11
 Total Risk

The total risk of a security can be viewed as consisting of

two parts:

Total security risk = Nondiversifiable risk (sys) +

Diversifiable risk (unsys)
 Diversifiable risk (unsystematic risk)

Represents the portion of an asset's risk that is

associated with random causes that can be
eliminated through diversification

It is attributable to firm-specific events, such as strikes,

lawsuits, regulatory actions or the loss of a key
account.
 Non diversifiable risk (systematic risk)

This is attributeable to market forces that affect all

firms, it cannot be eliminated through diversification.
Factors such war, inflation, the overall state of the
economy, international incidents and political events
 Beta - A Popular Measure of Risk
This is a relative measure of nondiversifiable risk. It
is an index of the degree of movement of an asset's
return in response to a change in the market return

The market return is the return on the market portfolio

of all traded securities.

Beta may be positive or negative.

The beta coefficient for the entire market equals 1
Selected beta coefficients and interpretations
If the market is expected to increase 10%, a stock
with a beta of 1.50 is expected to increase 15%
If the market went down 8%, then a stock with a
beta of 0.50 should only decrease by about 4%
Beta values for specific stocks can be obtained from
websites such as yahoo.com
Overall
Beta: 0.68
Market Cap(Mil.): CHF234,666.20
Shares Outstanding(Mil.): 3,188.40
Dividend: 2.20
Yield (%): 2.99
 Return of Investment
Properly stated, investors seek to maximize their returns from
investing, subject to the risk they are willing to incur.

In investments, it is important to distinguish between

expected return (the anticipated return for some future
period ) and a realised return ( the actual return over some
past period)

Investors invest for the future for the returns they expect to
earn but when the investing period is over, they are left
with their realised returns
 Return

Return is the motivating force in the investment process.

It is the reward for undertaking the investment.

The two components of return:

a) Yield The periodic cash flows (or income) on the
investment, either interest (from bonds) or dividends
(from stock)
 Return

b) Capital Gains (loss)

This the the appreciation (depreciation) in the price of

the asset, commonly called the capital gain (loss).

Add these two components together to form the total

return
Total return = Yield + Price changes
 Calculate the total returns for the
following

- A preferred stock bought for $70 per share, held one

year during which $5 per share dividends are collected
and sold for $62.

- A warrant bought for $10 and sold three months later

for $13
 Risk Premium

A risk premium is the additional return investors expect

to receive by taking on increasing amounts of risk.
 Risk Premiums
Return on Treasury Bills (T-Bills) is considered risk free
because a short maturity and a guarantee by the
Government.
Any return in excess of the T-Bill return is called the
investments risk premium.
Example
Equity risk permium is the difference between the
expected rate of return for stocks and a risk free rate .
It is the amount of extra return investors demand for
taking the extra risk involved in investing in shares
rather than buying treasury bills
10-26
 The Capital Asset Pricing Model
(CAPM)
Model that links the notions of risk and return

Helps investors define the required return on

an investment

As beta increases, the required return for a

given investment increases
 Risk and Return: The Capital Asset
Pricing Model (CAPM)
Measure how much additional return an investor should
expect from taking a little extra risk.

Using the beta coefficient to measure nondiversifiable

risk, the capital asset pricing model (CAPM) is

Required rate of return = Rf + [beta x (Rm - Rf)]

 CAPM (13)

Sally wishes to determine the required return on a stock

which has a beta of 1.5. The risk free rate of return is
7% , the return on the market is 11%. Calculate the
required rate of return
The higher the beta, the higher the required return, and
the lower the beta, the lower the required return.
 Conclusion

We must determine the level of risk each of us is

willing to accept.
An understanding of risk and return is a must in the
investment world.
Determine when professional help is needed.

10-31
 Tutorial 4 :Understanding risk return
1)What is risk?

2)What do you understand by the term risk tolerance

3) What is the fundamental principle of investing?

4) Discuss the types of risk faced by investors.

5) How do you manage investment decisions?

6)What is systematic risk?

7)What do you understand by the term Beta?

8)Discuss the risk return trade off on

a) Equities
b)Unit trust

9) Given that the beta is 0.75, the risk free return is 4% and
the return of the market is 7%, what is the required rate
of return?