RISK AND RETURNS

GROUP MEMBERS: 1. MARIA MOHD SALLEH 2. NORAFIDAH MOHD HASHIM 3. AMY ROSYILA ROMLI 4. FARIDAH HANIM ISMAIL

Outline
1. 2. 3. 4. 5. 6. 7. 8. Types of Returns Types of Investors Actual vs. Expected Returns Measurement of Risks Portfolio Diversification Capital asset pricing model (CAPM) The security market line (SML)

INTRODUCTION
One of the most important concepts in investment theory is the relationship between risk and return. The investors are exposed to risk in particular investment with uncertain expected returns. Investing in stock market is most riskier than investing in fixed income such as bond and short term financial.

RISK
Risk is defined as situation where the possibility of not achieving the expected value. Or can be define as the probability of uncertain future outcomes and possibility of losses The value of the risk is different between actual return and expected return from the investment. The higher different between actual and expected value the higher the risk is.

TYPES OF RETURNS
There are 3 types of returns: I. Actual return or holding period return II. Expected return or average return III. Required return

TYPES OF RETURNS

I. Actual Return Or Holding Period Return

Actual return is what investors actually receive from their investments. Actual return should not be confused with expected return, which is the projected return on an investment based on significant performance combined with forecast market trends. The formula for actual return is:
For instance, the actual return on a stock purchased at $100 whose value at the end of one year is $120 is said to have a return of $120 - $100 = $20 or 20% ($20 / $100). (ending value - beginning value) / beginning value = actual return

II. Expected Return Or Average Return The return that investors normally feel able to achieved from the investment Although this is what the investors expect the return to be, there is no guarantee that it will be the actual return. The difference between actual and expected return is due to systematic and unsystematic risk.

The disparity between the actual return and expected return on an investment provides an analytical framework in which to understand the reasons why an investment performed as it did, or why it performed differently than expected.

TYPES OF RETURNS
III. Required Return
Is the minimum return required by the investor in order for them to commit the dollars investment into uncertain future . The expected rate of return must be higher than the required rate of return before investors will participate.

TYPES OF INVESTORS
Three Types Of Basic Investors: I. Risk Averse Investors II. Risk- Seeking Or Risk lovers III.Risk- Indifferent ( Neutral ) Investors

The Risk-Averse investors The Investor are very much caution about the risk therefore they will stay away from adding high-risk stocks or investments to their portfolio and in turn will often lose out on higher rates of return. Investors looking for "safer" investments will generally stick to index funds and government bonds, which generally have lower returns.

Risk Seekers or Risk Lovers

Attracted to risk, meaning an investment with a lower expected return but greater risk As the level of risk increase, the investors dont have to require additional returns for additional risk.

Risk- Indifferent (Neutral ) Investors

Insensitive to risk investors who are not very much concerns about the risk as long as there are some returns.

Measurement of Return
Holding Period Return (HPR) or also known as Actual Return Expected return Average return Expected return based on Probability

Required rate of return

ACTUAL RETURN (HOLDING PERIOD RETURN OR HPR)

Holding period return is a very basic way to measure how much return you have obtained on a particular investment.

HPR Formula
Rit = (Pt Pt-1 + Dt) Pt-1
Where,

Rit

Return for stock i at period t (current period)

Pt
Pt-1 Dt

Price of a stock i at period t (current period)

Price of a stock i at period t-1 (previous period) Dividend paid at current period

Calculating HPR (Actual Return)

PERIOD 1989 1990 1991 1992 1993 1994 PRICE(P) 3.25 3.2 3.3 3.45 3.5 3.41 0.1 0.13 0.12 0.15 0.15 1.54 7.19 8.18 5.8 1.71 DIVIDEND (Dt) HPR (Ri %)

1995
1996 1997

3.14
3.25 3.3

0.11
0.1 0.16

-4.69
6.69 6.46

Cont.
Rit = (3.2 3.25 + 0.1) 3.25 = 0.0154 = 0.0154 x 100 =1.54%

Expected (Average Return)

E (R) = Sum of holdings period return (HPR) Number of holding period E (R) = R1 + R2 + R3 + R4 + R5 + R6 + R7 + R8 N E (R) = 1.54 + 7.19 + 8.18 +5.80 + 1.71 -4.69 +6.69 +6.46 8 = 4.11%

Expected Return based on Probability

E (R) =
Expected return is the average of a probability distribution of possible returns, calculated by using the following formula:

R (s) = return from investment subject to various economic scenario P (s) = probability of associated with return

Returns associated with Probability

State of the economy (s) Great Good So-So Bad Probability associated with return (P) 0.2 0.4 0.3 0.1 Return from P(s) x R(s)

investment ( R ) (%)
25 15 5 -5 5% 6% 1.50% -0.50% (R) = P (s) x R(s) = 12%

E (R) = 0.2 (25%) + 0.4 (15%) + 0.3 (5%) + 0.1 (-5%) = 12%

P=1

R = 40

Measurement of Risk

RISK
Probability of incurring harm For investors, risk is the probability

of earning an inadequate return.

If investors require a 10% rate of return on a given investment, then any return less than 10% is considered harmful.

Differences in Levels of Risk - Illustrated

Outcomes that produce harm Probability The wider the range of probable outcomes the greater the risk of the investment. A is a much riskier investment than B

-30% -20%

-10%

0%

10% 20% 30% 40% Possible Returns on the Stock

STANDARD DEVIATION

(Ri E (R))

Where, E(R) = expected return for stock I R it = actual return for stock i at period t

EXAMPLE 3
PERIOD 1989 1990 1991 1992 1993 1994 1995 1996 1997 PRICE(P) 3.25 3.2 3.3 3.45 3.5 3.41 3.14 3.25 3.3 0.1 0.13 0.12 0.15 0.15 0.11 0.1 0.16 1.54 7.19 8.18 5.8 1.71 -4.69 6.69 6.46 DIVIDEND (Dt) HPR (Ri %)

Using the information from table above, calculated the standard deviation.

(Ri E (R))

= 1 / 8-1

[(1.54 4.11) + (7.19 4.11) + (8.18 4.11) + (5.80 4.11) + (1.71 4.11) + (-4.69 4.11) + (6.69 4.11) + (6.46 4.11)]

= 4.32%

Portfolio
The monetary return experienced by a holder of a portfolio. Portfolio returns can be calculated on a daily or long-term basis to serve as a method of assessing a particular investment strategy. Dividends and capital appreciation are the main components of portfolio return.
http://www.investopedia.com/terms/p/portfolio\return

Portfolio Return
The expected return of a portfolio is a weighted average of the expected return of individual assets in the portfolio.
Portfolio Return (Rp) =
Where, E(Ri) Wi

Wi E (Ri)

= expected return of asset i in the portfolio = proportion of investment in particular asset i

Example 1
Assume that you have RM 10,000 and wanted to invest RM 5,000 in the stock market and another RM 5,000 in bond market. If the expected return from the stock market and bond market are 15% and 8% respectively, the portfolio return (Rp) is: = = = (5000/10000)
Rp
Wi E (Ri) Ws Rs + Wb Rb

(5000/10000) x 15% + x 8% 0.5 11.5%

= =

Example 2
Ahmad is considering of buying Maybank and Maxis shares from KLSE. Below are some of the information available for Maybank and Maxis.
Maybank Expected return 8% Maxis 12%

Proportion of investment

0.40

0.60

What is the expected portfolio return?

Rp
= =

= WMb RMb + WMax RMax 0.40( 8%) + 0.60 (12%) 10.4%

Portfolio Risk
Variability of its return Investors had a tool that they could use to dramatically reduce the risk of the portfolio without a significant reduction in the expected return of the portfolio.

CONT.

p (wA ) 2 ( A ) 2 (wB ) 2 ( B ) 2 2(wA )(wB )( A, B )( A )( B )

Where, p = the portfolio variance WA = proportion of investment in asset A WB = proportion of investment in asset B A = the variance of return A = the variance of return B AB = correlation coefficient between A and B