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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