1.

0 Introduction

Whether it is investing, driving or just walking down the street, everyone exposes
themselves to risk. Your personality and lifestyle play a big role in how much risk you are
comfortably able to take on. If you invest in stocks and have trouble sleeping at night,
you are probably taking on too much risk. Risk is defined as the chance that an
investment's actual return will be different than expected. This includes the possibility of
losing some or all of the original investment.

A financial decision typically involves risk. For example, a company that borrows money
faces the risk that interest rates may change, and a company that builds a new factory
faces the risk that product sales may be lower than expected. These and many other
decisions involve future cash flows that are risky. Investors generally dislike risk, but
they are also unable to avoid it.

To make effective financial decisions, managers need to understand what causes risk,
how it should be measured and the effect of risk on the rate of return required by
investors. These issues are discussed in this chapter using the framework of portfolio
theory, which shows how investors can maximize the expected return on a portfolio of
risky assets for a given level of risk. The relationship between risk and expected return is
first described by the capital asset pricing model (CAPM), which links expected return to
a single source of risk, and second, by models that include additional factors to explain
returns. To understand clearly it is necessary to understand what is meant by return and
risk.

1
2.0 Return and Risk

The return on an investment and the risk of an investment are basic concepts in finance.
Return on an investment is the financial outcome for the investor. For example, if
someone invests $100 in an asset and subsequently sells that asset for $111, the dollar
return is $11. Usually an investment’s dollar return is converted to a rate of return by
calculating the proportion or percentage represented by the dollar return. For example, a
dollar return of $11 on an investment of $100 is a rate of return of $11/$100, which is
0.11, or 11 per cent.

Risk is present whenever investors are not certain about the outcomes an investment
will produce. Suppose, however, that investors can attach a probability to each possible
dollar return that may occur. Investors can then draw up a probability distribution for the
dollar returns from the investment. A probability distribution is a list of the possible dollar
returns from the investment together with the probability of each return.

2
3.0 Risk-Return of Single Asset

Risk and return

In general, risk means a hazard or exposure to loss or injury. In finance, risk refers to a

chance of a monetary loss (Rodziah Abd Samad, Rohani Abdul Wahab, Shelia

Christabel & Mohd Nizal Haniff , 2010).

In finance, return can be described as the reward for investing. It consists of periodic

cash payments or current income and capital gains (losses) or increase (decreases) in

market value (Rodziah Abd Samad, Rohani Abdul Wahab, Shelia Christabel & Mohd

Nizal Haniff , 2010).

Systematic risk

It is also known as non-diversifiable risk. It is results from forces outside the firm’s

control and is therefore not unique to the given security. For instance, systematic risks

are purchasing power risk and interest rates risk.

Unsystematic risk

It is also known as diversifiable risk or unique risk. They are risk that are specific to a

particular firms or industries in the economy. Sources of unsystematic risk include

business risk, liquidity risk and default risk.

Example 1

Abdul purchased 100 shares of Jaya stock at RM10 per share. He held the shares for

one year during which time, he received dividends of RM0.80 per share. At the end of a

year, he sold the shares when they were RM45 per share.

3
Solution

In this situation, Abdul would receive two types of return, that is current income which is

100 shares x RM0.80 = Rm80, and capital gain of RM 3,500 [100 shares(RM45-RM10)].

Therefore, his total return is RM3,580 (RM80 + RM3,500).

Example 2

Suppose that by the end of the year, Jaya’s stock price falls to RM1 per share. In this

case, Abdul’s total return would be the dividend income of RM80 plus the capital loss of

RM900 [100 shares(RM1-RM10)], which equal to a loss of RM820.

Measurement of return

Holding Period Return (HPR)

Formulae:

HPR = Current income + Capital gain (loss)

Purchase price

Example 3

Delia purchase one lot of EZ shares for RM5 per share in Jan 2009 and sold the shares

in Dec 2009 for RM8 per share. In 2009, she received dividends of RM0.85 per share.

Calculate Delia’s HPR.

Solution

HPR = (RM0.85 x 100 shares) + (RM8-RM5) 100 shares

RM5 x 100 shares

= 77%

4
Expected return

Formulae :

Expected return = ∑ (Pi x Ri)

Where

Pi = probability of occurrence of i th return

Ri = return associated with the i th return

n = number of possible outcomes

Example 4

Anis is considering buying Milo stocks. If there is a 20% chance of getting 12% return, a

30% chance of getting 15% return, a 40% chance of getting 10% return and a 10%

chance of getting 5% return, compute Anis’s expected return.

Solution

Expected return = (0.20)(12)+(0.30)(15)+(0.40)(10)+(0.10)(5)

= 11.4%

Measuring risk

Risk can be computed in terms of variance and standard deviation (sd).

5
Example 5

Let us assume that asset T had returns of 15%, 17%, 8%, -14% and 5% over the recent

5 years.

The average return = 15%+17%+8%+(-14%)+5%

= 6%

To calculate the variance, square each deviations, add them up and divide the outcome

by the no. of returns, minus one as below:

(15-6)² = (9)² = 81

(17-6)² = (11)² = 121

(8-6)² = (2)² = 4

(-14-6)² = (-20)² = 400

(4-6)² = (-2)² = 4

Total 610

Ơ² 610 = 152.5

(5-1)

Hence, its sd equals to 12.349%.

6
7
4.0 Risk Return of Portfolio Assets

4.1 Portfolio

A portfolio is a grouping of financial assets such as stocks, bonds and cash

equivalents, as well as their mutual fund, exchange-traded fund and closed-fund
counterparts. Portfolios are held directly by investors or managed by financial
professionals. Investors should construct an investment portfolio in accordance
with their risk tolerance and investing objectives. Think of an investment portfolio
as a pie that is divided into pieces of varying sizes representing different asset
classes and/or types of investments to accomplish an appropriate risk return
portfolio allocation.

4.2 The Portfolio Management Process

The portfolio management process is the method an investor uses to aid him in
meeting his investment goals. The procedure is as follows:

i. Create a Policy Statement – A policy statement is the statement that

contains the investor's goals and constraints as they relate to his
investments.
ii. Develop an Investment Strategy – This entails creating a strategy that
combines the investor's goals and objectives with current financial market
and economic conditions.
iii. Implement the Plan Created – This entails putting the investment strategy to
work by investing in a portfolio that meets the client's goals and constraint
requirements.
iv. Monitor and Update the Plan – Both markets and investors' needs change
as time passes. As such, it is important to monitor for these changes as they
occur and to update the plan to adjust accordingly.

4.3 Portfolio Return

The expected return of a portfolio is the weighted average of expected returns of

the securities held in a portfolio. The weights are based on the proportion of total
funds increased in each security. Simply, the weight is the percentage of each

8
asset’s investment to the total funds or total investment. The weight of each
investment is computed as below:

Weight of asset 1 = Funds invested in asset 1

Total investment

Example 1:

Mr Ahmad invests RM2,500 in stock K, RM5,500 in stock W and RM4,000 in

stock J. The expected returns from the investment in the stocks are as follows:

Stock Expected Return

K 10%
W 15%
J 20%

The value of Mr Ahmad’s portfolio

= RM2,500 + RM5,500 + RM4,000 = RM12,000

The percentage of the portfolio in stock K

= RM2,500 / RM12,000 = 0.2083 @ 20.83%

The percentage of the portfolio in stock W

= RM5,500 / RM12,000 = 0.4584 @ 45.84%

The percentage of the portfolio in stock J

= RM4,000 / RM12,000 = 0.3333 @ 33.33%

9
Expected return of the portfolio is computed as follows:

Stock Weight (%) Expected Return (%) Weighted Return (%)

K 20.83 10 2.083
W 45.84 15 6.876
J 33.33 20 6.666
15.625

Example 2:

Mr Adam owns a portfolio that has RM18,000 in stock M and RM32,000 in stock
P. He expects stock M and stock P to earn a return of 15% and 28%
respectively. Compute the expected return on this portfolio.

Stock Fund (RM) Weight Expected Weighted

Return Return
M 18,000 18,000/50,000 15% 5.40
P 32,000 32,000/50,000 28% 17.92
23.32%

Example 3:

10
5.0 The Capital Asset Pricing Model (CAPM)

Pronounced as though it were spelled "cap-m," this model was originally developed in
1952 by Harry Markowitz and fine-tuned over a decade later by others, including William
Sharpe. The capital asset pricing model (CAPM) describes the relationship between risk
and expected return, and it serves as a model for the pricing of risky securities.

Kak Yati added here..

11
6.0 Conclusion

There are two important aspects of investment, which is the expected return and risk of
the investment. In evaluating the desirability of any given investment, the financial
manager must consider not only the risk of the investment but also the impact of the
investment in overall risk. The financial manager must be able to calculate the two
elements, that is risk and expected return before making a decision. The financial
manager must also realize that he would only be able to minimize or eliminate the
unsystematic risk and not the systematic risk.

12
7.0 References

Rodziah Abd Samad, Rohani Abdul Wahab, Shelia Christabel & Mohd Nizal Haniff

(2010). Financial Management For Beginners. (3rd ed.). Malaysia : McGraw-Hill

(Malaysia) Sdn. Bhd.

Ross, S.A., Westerfield, R.W. & Jordan, B.D. (2011). Essentials of Corporate Finance.

(7th ed.). New York : McGraw-Hill Irwin.

13