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Investment Planning
By:
Associate Professor Dr. GholamReza Zandi
[email protected]
Introduction
• Investment Planning include exposure to the
major and alternative asset classes
• Investment in major asset classes can be either
direct or indirect through a managed fund
• In order to build a portfolio the investor must
have appreciation of risk and return attributes
• Risk and return trade-offs are inherent in all
investment analysis
General Attributes of Investors
• Investors are classified into various groups based on
their tolerance to risk, their preference for income
versus capital growth and their investment timeframe
• Defensive investors are more risk averse and are
focused on preserving capital
• Aggressive investors have more tolerance towards
risk and focus on capital growth
• Financial planners use these classifications to
determine the appropriate asset mix for their clients.
General Attributes of Investors
• Table 4.1 —A general investor classification:
Broad Investment Classes
• The main investment choices are:
– cash
– fixed Interest
– property
– shares.
Cash
• Can be used as a safe haven
• Can provide liquidity and stable return
• Considered low risk or risk free ( for example, the
Federal Government 90 day Treasury Note interest
rate is regarded as the risk free rate in Australia)
• Can be adversely affected by tax and inflation
• Return is low and investment term is short
• Cash investments can include savings accounts,
money market securities and cash-management trusts
Fixed Interest
• Fixed term (e.g. term deposit, debenture or
government or corporate bond)
• Fixed interest rate with interest paid on a regular basis
(a bond) or factored into the final payment and
offered as a discount security (a bank bill)
• Issued by institutions and government and semi
government authorities
• Longer investment horizon than cash
• Low risk — corporate bonds are riskier than
government bonds
Fixed Interest
• Generally secured apart from unsecured notes
which are riskier
• Hybrid instruments — instruments that have some
characteristics of debt and equity (e.g. a
convertible note is debt but may be converted to a
share at a future date)
• Can have a stabilising effect upon a portfolio
• Credit risk can be an issue — more so with
corporate bonds
Property
•
•
•
•
Longer term investment vehicle
Usually provides regular rental income
Riskier than bonds but lower risk than shares
Direct property consist of rental properties;
residential, commercial, industrial or rural
• Indirect property investment includes listed
property trusts and unlisted property trusts
Property
• Drawbacks:
–
–
–
–
–
–
–
Not liquid
It takes time to buy and sell
Transaction costs are high
Diversification can be limited for the smaller investor
Ongoing care and maintenance
Listed property trusts can have similar risk to shares
During the GFC many listed trusts suffered severe falls in
value when they were unable to refinance debt and were
forced to sell property when the market was at its worst
Shares/Equities
• Shares are generally high risk and return and
therefore suitable for longer term investors
• In the long term Australian shares have provided long
term growth well above inflation — but in the short
term market returns can be quite volatile
• Share market returns tend to move in cycles reflecting
such factors as economic growth, industry trends,
company profitability, inflation, interest rate
expectations and general market sentiment
Shares/Equities
• Short term volatility of shares versus bonds and cash:
Shares/Equities
• Returns can be both capital growth and dividends
• An investor can buy shares on international shares
and get exposure to markets at different stages of the
business cycle
• International shares can provide good diversification
but are exposed to foreign currency risk
– A rising in your national currency can wipe out gains made
on international markets — when shares are sold and the
foreign currency is exchanged for national currency the
investor will receive fewer amount
– The reverse will also be true
The Risk And Return Relationship
• The higher the return the greater risk
• Inflation–adjusted rates of return:
– The real rate of return is the nominal rate of return
adjusted for the effect of inflation
– It is calculated as:
R(real) = [1 + R (nom)/1+h] – 1
Where h = the rate of inflation.
The Risk And Return Relationship
• Definitions of risk:
– The chance of loss of capital — a negative real
return
– The chance of loss of purchasing power — will
returns be greater or less than the inflation rate?
– The variability of returns — The Standard
Deviation is the measure of risk (i.e. the variability
of returns around an expected mean)
Risk and Return Fundamentals
• In most important business decisions there are two
key financial considerations: risk and return.
• Each financial decision presents certain risk and
return characteristics, and the combination of these
characteristics can increase or decrease a firm’s share
price.
• Analysts use different methods to quantify risk
depending on whether they are looking at a single
asset or a portfolio—a collection, or group, of assets.
8-16
Risk and Return Fundamentals
• Risk is a measure of the uncertainty surrounding the
return that an investment will earn or, more formally,
the variability of returns associated with a given asset.
• Return is the total gain or loss experienced on an
investment over a given period of time; calculated by
dividing the asset’s cash distributions during the
period, plus change in value, by its beginning-ofperiod investment value.
8-17
Risk and Return Fundamentals
The expression for calculating the total rate of return earned on any
asset over period t, rt, is commonly defined as
where
rt = actual, expected, or required rate of return during period t
Ct = cash (flow) received from the asset investment in the time
period t – 1 to t
Pt = price (value) of asset at time t
Pt – = price (value) of asset at time t – 1
1
8-18
Risk and Return Fundamentals
At the beginning of the year, Apple stock traded for $90.75 per
share, and Wal-Mart was valued at $55.33. During the year,
Apple paid no dividends, but Wal-Mart shareholders received
dividends of $1.09 per share. At the end of the year, Apple stock
was worth $210.73 and Wal-Mart sold for $52.84.
What is the annual rate of return, r, for each stock ?
8-19
Solution
Apple: ($0 + $210.73 – $90.75) ÷ $90.75 =
132.2%
Wal-Mart: ($1.09 + $52.84 – $55.33) ÷ $55.33 =
–2.5%
Risk and Return Fundamentals
Economists use three categories to describe how
investors respond to risk.
– Risk averse is the attitude toward risk in which investors
would require an increased return as compensation for an
increase in risk.
– Risk-neutral is the attitude toward risk in which investors
choose the investment with the higher return regardless of
its risk.
– Risk-seeking is the attitude toward risk in which investors
prefer investments with greater risk even if they have lower
expected returns.
8-21
Risk of a Single Asset: Risk Assessment
• Scenario analysis is an approach for assessing risk
that uses several possible alternative outcomes
(scenarios) to obtain a sense of the variability among
returns.
– One common method involves considering pessimistic
(worst), most likely (expected), and optimistic (best)
outcomes and the returns associated with them for a given
asset.
• Range is a measure of an asset’s risk, which is found
by subtracting the return associated with the
pessimistic (worst) outcome from the return
associated with the optimistic (best) outcome.
8-22
Risk of a Single Asset: Risk Assessment
Norman Company wants to choose the better of two investments, A and B.
Each requires an initial outlay of $10,000 and each has a most likely annual
rate of return of 15%. Management has estimated the returns associated with
each investment. Asset A appears to be less risky than asset B. The risk
averse decision maker would prefer asset A over asset B, because A offers
the same most likely return with a lower range (risk).
8-23
Risk of a Single Asset:
Risk Assessment
• Probability is the chance that a given outcome will
occur.
• A probability distribution is a model that relates
probabilities to the associated outcomes.
• A bar chart is the simplest type of probability
distribution; shows only a limited number of
outcomes and associated probabilities for a given
event.
• A continuous probability distribution is a
probability distribution showing all the possible
outcomes and associated probabilities for a given
event.
8-24
Risk of a Single Asset:
Risk Assessment
Norman Company’s past estimates indicate that the
probabilities of the pessimistic, most likely, and optimistic
outcomes are 25%, 50%, and 25%, respectively. Note that
the sum of these probabilities must equal 100%; that is, they
must be based on all the alternatives considered.
8-25
Bar charts for asset A’s and
asset B’s returns
8-26
Continuous Probability Distributions
8-27
Risk of a Single Asset:
Risk Measurement
• Standard deviation (r) is the most common statistical
indicator of an asset’s risk; it measures the dispersion around
the expected value.
• Expected value of a return (r) is the average return that an
investment is expected to produce over time.
where
rj = return for the jth outcome
Prt = probability of occurrence of the jth outcome
n = number of outcomes considered
8-28
Expected Values of Returns for
Assets A and B
8-29
Risk of a Single Asset:
Standard Deviation
The expression for the standard deviation of
returns, r, is
In general, the higher the standard deviation, the
greater the risk.
8-30
The Calculation of the Standard Deviation of the Returns for
Assets A and B
8-31
The Calculation of the Standard Deviation of
the Returns for Assets A and B
8-32
Risk of a Single Asset:
Coefficient of Variation
• The coefficient of variation, CV, is a measure of
relative dispersion that is useful in comparing the
risks of assets with differing expected returns.
• A higher coefficient of variation means that an
investment has more volatility relative to its expected
return.
8-33
Risk of a Single Asset:
Coefficient of Variation
Using the standard deviations and the expected
returns (from Table 8.3) for assets A and B to
calculate the coefficients of variation yields the
following:
CVA = 1.41% ÷ 15% = 0.094
CVB = 5.66% ÷ 15% = 0.377
8-34
Personal Finance Example
What is expected rate of return and risk of the stock over 2010-2012?
8-35
Solution
Solution
Assuming that the returns are equally probable:
8-37
Risk of a Portfolio
• In real-world situations, the risk of any single
investment would not be viewed independently
of other assets.
• New investments must be considered in light
of their impact on the risk and return of an
investor’s portfolio of assets.
• The financial manager’s goal is to create an
efficient portfolio, a portfolio that maximum
return for a given level of risk.
8-38
How Can Diversification Reduce Risk?
• For a portfolio of shares, we must consider the risk
and returns of the whole portfolio rather than just the
return of the individual shares in the portfolio
• The expected return for a portfolio is the weighted
average return of the individual shares in the portfolio
Risk of a Portfolio: Portfolio
Return and Standard Deviation
The return on a portfolio is a weighted average of the
returns on the individual assets from which it is formed.
where
wj = proportion of the portfolio’s total
dollar value represented by asset j
rj = return on asset j
8-40
Risk of a Portfolio: Portfolio Return and
Standard Deviation
James purchases 100 shares of Wal-Mart at a price of
$55 per share, so his total investment in Wal-Mart is
$5,500. He also buys 100 shares of Cisco Systems at
$25 per share, so the total investment in Cisco stock is
$2,500.
– Combining these two holdings, James’ total portfolio is
worth $8,000.
– Of the total, 68.75% is invested in Wal-Mart
($5,500/$8,000) and 31.25% is invested in Cisco Systems
($2,500/$8,000).
– Thus, w1 = 0.6875, w2 = 0.3125, and w1 + w2 = 1.0.
8-41
Expected Return, Expected Value, and Standard
Deviation of Returns for Portfolio XY
8-42
Expected Return, Expected Value, and
Standard Deviation of Returns for
Portfolio XY
8-43
Risk of a Portfolio: Correlation
• Correlation is a statistical measure of the relationship
between any two series of numbers.
– Positively correlated describes two series that move in the same
direction.
– Negatively correlated describes two series that move in opposite
directions.
• The correlation coefficient is a measure of the degree of
correlation between two series.
– Perfectly positively correlated describes two positively correlated
series that have a correlation coefficient of +1.
– Perfectly negatively correlated describes two negatively correlated
series that have a correlation coefficient of –1.
8-44
Correlations
8-45
Risk of a Portfolio: Diversification
• To reduce overall risk, it is best to diversify by
combining, or adding to the portfolio, assets that have
the lowest possible correlation.
• Combining assets that have a low correlation with
each other can reduce the overall variability of a
portfolio’s returns.
• Uncorrelated describes two series that lack any
interaction and therefore have a correlation
coefficient close to zero.
8-46
Diversification
8-47
Forecasted Returns, Expected Values, and Standard Deviations
for Assets X, Y, and Z and Portfolios XY and XZ
8-48
Portfolio Risk
General Electric (GE)
Exxon (XON)
Dow Chemical (DOW)
Probability
Return (%)
Probability
Return (%)
Probability
Return (%)
0.25
10
0.10
6
0.20
9
0.35
14
0.60
12
0.55
15
0.40
20
0.30
18
0.25
21
Correlation of returns on GE and XON = +0.85
Correlation of returns on GE and DOW = +0.70
Correlation of returns on XON and DOW = +0.75
Compute the expected return and standard deviation of return if you invest
1- RM 60,000 in GE, RM 40,000 in XON
2- RM 20,000 in DOW and RM 80,000 in XON
Solution
• E(RGE) = 0.25(10) + 0.35(14) + 0.40(20) = 15.4%
SD(GE) =
(10 - 15.4)2(0.25) + (14 - 15.4)2(0.35) +
(20 - 15.4)2(0.40) = 4.05%
• E(RXON) = 0.10(6) + 0.60(12) + 0.30(18) = 13.2%
• SD(XON) =
(6 - 13.2)2(0.10) + (12 - 13.2)2(0.60)
+ (18 - 13.2)2(0.30) = 3.6%
•
• E(RDOW) = 0.20(9) + 0.55(15) + 0.25(21) = 13.2%
• SD(DOW) =
(9 - 15.3)2(0.20) + (15 - 15.3)2(0.55)
+ (21 - 15.3)2(0.25) = 4.01%
•
Solution
• i. Invest RM 60,000 in GE and RM 40,000 in XON.
E(RGEXON) = 0.6(15.4%) + 0.4(13.2%) = 14.52%
GEXON =
0.62(4.05)2 + 0.42(3.6)2 +
2(0.6)(0.4)(0.85)(4.05)(3.6) = 3.73
• ii. Invest RM 20,000 in DOW and RM80,000 in XON.
E(RDOWXON) = 0.2(13.2%) + 0.8(13.2%) = 13.2%
DOWXON =
0.22(4.01)2 + 0.82(3.6)2 +
2(0.2)(0.8)(0.75)(4.01)(3.6) = 3.52%
Solution
• WHICH ONE TO INVEST?
Coefficient of variation (SD/Mean) for each
portfolio;
• CV for GEXON = 3.73/14.52 = 0.256
• CV for DOWXON = 3.52/13.2 = 0.266
Risk of a Portfolio: Correlation,
Diversification, Risk, and Return
Consider two assets—Lo and Hi—with the
characteristics described in the table below:
8-53
How Can Diversification Reduce Risk?
• The correlation coefficient shows the extent of
correlation among shares
• It has a numerical value of –1 to +1 which indicates
the extent of risk reduction within a portfolio:
– Negative correlation (–1)  Large risk reduction
– Positive correlation (+1)  No risk reduction
• On average, the correlation coefficient for returns on
two randomly selected shares would be in the range
of +0.5 to +0.7
Possible Correlations
8-55
How Can Diversification Reduce Risk?
Share Share
Correlation
C
D
Coefficient
Standard deviation 4% 4% –0.1 0.2 0.6 1.0
Portfolio risk
0% 3.1% 3.6% 4%
(Standard deviation of the portfolio)
• Providing the correlation coefficient between
shares C and D is less than 1.0, investor will be able to
make a higher return at reduced risk
Application Of The Diversification Decision
• The efficient portfolio — investors have return
and risk data for a collection of securities
• This data can be graphed as an upward sloping
concave curve called the ‘efficient frontier’
• The frontier is a series of portfolios with different
combinations of portfolio risk and return
• For every level of risk, the portfolio with the
highest return is the efficient one which is on the
line
• All other portfolios at that level of risk are
inefficient
Application Of The Diversification Decision
• The risk–return ratio can be optimised by
combing securities with a minimised covariance
— a negative covariance would be optimal
• The efficient frontier shows where the most
efficient portfolios are located whereas the
Sharpe ratio identifies the best possible
proportions of these securities to use within a
portfolio
Application Of The Diversification Decision
• Relationship between the efficient frontier and the Sharpe
ratio:
Application Of The Diversification Decision
• Modern portfolio theory assumes there are
only two asset types
– risky assets
– risk-free assets
• Financial planners need to help clients make
decisions about investments in
– growth assets
– fixed-interest assets
Application Of The Diversification Decision
• Modern portfolio theory states the
risk-return relationship by the formula:
 E (Rpi )  Rf
E(R p )  Rf  
σpi


 σp

where:
E(Rp)
= expected return on entire portfolio
E(Rpi)
= expected return on the risky fund
p = standard deviation of entire portfolio
pi
= standard deviation of risky fund
Rf = risk-free interest rate
Risk and Return: The Capital Asset
Pricing Model (CAPM)
• The capital asset pricing model (CAPM) is the basic theory
that links risk and return for all assets.
• The CAPM quantifies the relationship between risk and return.
• In other words, it measures how much additional return an
investor should expect from taking a little extra risk.
8-62
Risk and Return: The CAPM:
Types of Risk
• Total risk is the combination of a security’s nondiversifiable
risk and diversifiable risk.
• Diversifiable risk is the portion of an asset’s risk that is
attributable to firm-specific, random causes; can be eliminated
through diversification. Also called unsystematic risk.
• Nondiversifiable risk is the relevant portion of an asset’s risk
attributable to market factors that affect all firms; cannot be
eliminated through diversification. Also called systematic risk.
• Because any investor can create a portfolio of assets that will
eliminate virtually all diversifiable risk, the only relevant risk
is nondiversifiable risk.
8-63
Risk Reduction
8-64
Risk and Return: The CAPM
• The beta coefficient (b) is a relative measure of Nondiversifiable risk. An index of the degree of
movement of an asset’s return in response to a change
in the market return.
– An asset’s historical returns are used in finding the asset’s
beta coefficient.
– The beta coefficient for the entire market equals 1.0. All
other betas are viewed in relation to this value.
• The market return is the return on the market
portfolio of all traded securities.
8-65
Selected Beta Coefficients and Their Interpretations
8-66
Beta Coefficients some Stocks
8-67
Risk and Return: The CAPM
• The beta of a portfolio can be estimated by using the
betas of the individual assets it includes.
• Letting wj represent the proportion of the portfolio’s
total dollar value represented by asset j, and letting bj
equal the beta of asset j, we can use the following
equation to find the portfolio beta, bp:
8-68
Mario Austino’s Portfolios V and W
What is the betas for the two portfolios:
bv and bw?
8-69
Risk and Return: The CAPM
The betas for the two portfolios, bv and bw, can be calculated
as follows:
bv = (0.10  1.65) + (0.30  1.00) + (0.20  1.30) +
(0.20  1.10) + (0.20  1.25)
= 0.165 + 0.300 +0 .260 + 0.220 + 0.250 = 1.195 ≈ 1.20
bw = (0.10  .80) + (0.10  1.00) + (0.20  .65) + (0.10  .75) +
(0.50  1.05)
= 0.080 + 0.100 + 0.130 +0 .075 + 0.525 = 0.91
8-70
Risk and Return: The CAPM
Using the beta coefficient to measure nondiversifiable risk,
the capital asset pricing model (CAPM) is given in the
following equation:
rj = RF + [bj  (rm – RF)]
where
rt = required return on asset j
RF = risk-free rate of return, commonly measured by the return
on a U.S. Treasury bill
bj = beta coefficient or index of nondiversifiable risk for asset j
rm = market return; return on the market portfolio of assets
8-71
Risk and Return: The CAPM
The CAPM can be divided into two parts:
1. The risk-free rate of return, (RF) which is the required
return on a risk-free asset, typically a 3-month U.S.
Treasury bill.
2. The risk premium.
• The (rm – RF) portion of the risk premium is called the market risk
premium, because it represents the premium the investor must
receive for taking the average amount of risk associated with
holding the market portfolio of assets.
8-72
Risk and Return: The CAPM
Historical Risk Premium
8-73
Risk and Return: The CAPM
Benjamin Corporation, a growing computer software developer,
wishes to determine the required return on asset Z, which has a
beta of 1.5. The risk-free rate of return is 7%; the return on the
market portfolio of assets is 11%. Substituting bZ = 1.5, RF = 7%,
and rm = 11% into the CAPM yields a return of:
8-74
Solution
rZ = 7% + [1.5  (11% – 7%)] = 7% + 6% = 13%
General Investment Strategies
• Diversification — ‘don’t put all your eggs in
one basket’
• Diversification raises the question as to how an
investment portfolio should be allocated
• Investors must have allocation decisions based
on their risk–return profile
General Investment Strategies
• Risk tolerance will be:
– Partly innate
– Governed by:
•
•
•
•
•
a person’s age
income
wealth
years to retirement
past financial experiences.
General Investment Strategies
• Gibson (2000) argued that holding four asset classes in a
portfolio (multiple-asset class investing) would reduce the
risk of the portfolio and increase its average return
• This happens because the four asset classes are not
strongly related to each other
– As one asset class performs well the others are less likely to
perform as well and as the better performing asset class reverses
its performance the other asset classes tend to perform better
– The performances tend to counteract each other which provides
for a better long term average return and lower level of risk of
such a portfolio
Investor Behaviour
• The traditional view is that markets are
efficient and that investors are rational —
Efficient Market Theory
• This view is challenged by advocates of
Behavioural Finance Theory who argue that
people sometimes display irrational behaviour
Investor Behaviour
• Some irrational behaviour observed:
– Loss aversion — prospect theory: investors dislike
losses a lot more than they like equal gains
– Herding — people tend to follow crowd behaviour
– Overconfidence — many investors mistakenly
believe they can beat the market resulting in
overtrading and more losses
– Biased judgements — ‘house prices never go
down’
Investment Scams
• Common factors among all scams include:
– Product Disclosure Statement is not provided
– High returns are promised
– A password or bank account details are required
– Investments are often based overseas or hidden
• Ponzi schemes — the most simple yet
effective of scams where money from new
investors is used to pay dividends to the older
investors
Information Sources For Investment Choices
• Economic fundamentals
• Industry characteristics and reports
• Company background, prospects, annual
reports
• Current market prices
• Government reports, ASIC website
• Analyst reports
• Using the internet as a search engine
The End