MPU 3353

Personal Financial Planning in

Malaysia

Investment Basics:
The Management of Risk

10-1
 Introduction
Risk is a fundamental component of investing.
Risk must be understood and managed.
Diversification is an important way to manage risk.
Professional investors know that diversification
involves diversification across asset classes as well as
within asset groups.
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.

10-2
 Chapter Objectives
1. To see the importance of diversification and to understand
how it reduces investment risk
2. To understand how to accomplish adequate diversification,
both among asset groups and within an asset group
3. To become familiar with important methods and issues
involved in establishing a portfolio and making changes over
time

10-3
 Topic Outline

The Rewards of Diversification

Applying a Risk-Return Model
Building and Changing a Portfolio

10-4
A Portfolio

A Portfolio is
simply a group of
Stocks
assets held at the
same time.
Bills

10-5
 Why Diversification Works
Diversification means owning a variety of
investments.
The portfolio of investments can have less risk than
the individual investments due to correlation.
Diversification lowers investment risk because:
Asset returns are poorly correlated.
The return correlations among stocks, bonds, and T-bills
are low so holding these investments in a portfolio is an
effective way to reduce risk.
Diversification is not effective if asset returns are strongly
positively correlated.

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An Example of Negative Return
Correlation

10-7
 Diversification Guidelines

Diversify among intangibles and tangibles

Remember: A house is a major tangible asset.
Diversify globally
Invest in foreign securities
Diversify within asset groups
Own a variety of common stocks

10-8
Portfolio Risk and the Number of
Stocks Held

10-9
 Random and Market Risks
Random risks are those associated with specific
companies. This risk can be eliminated by owning a
sufficient number of stocks.
These tend to balance out if a sufficient number of stocks
are owned (about 20).
Holding too few stocks is foolish because you are taking
risks that can be eliminated.
Market risk is the risk associated with the overall
market.
It cannot be reduced by owning more stocks.

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 Managing Market Risk
Market risk cannot be eliminated; it must be managed.
You manage risk by earning a return that compensates
you for the risk that you are assuming.
Market risk is measured by a statistical measure
known as beta.
If your portfolio is as risky as the overall stock
market, you should earn the market risk premium.
If your portfolio is more risky than the overall stock
market, you should earn more than the market risk
premium.

10-11
 The Beta Risk Measurement
Beta is a statistical measure that compares the risk of
an individual stock to the risk of the entire market.
If a stock has a beta greater than 1, it is considered
more risky than the overall stock market.
Therefore, the return for this stock should be greater than
the return of the overall stock market.
If a stock has a beta less than 1, it is less risky than
the overall stock market.
The return for this stock should be less than the return for
the overall stock market.

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 Estimating a Stocks Required Return
using CAPM
First, determine the stocks risk premium
Find its beta (example: 1.5)
Multiply the beta by the market risk premium (say, 8%)
Market risk premium = 1.5 8% = 12%
Second, add the current risk-free rate (say 5%)
Required return = 12% + 5% = 17%

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CAPM is most often used to determine what the fair
price of an investment should be.

This rate can then be used to discount the investment's

future cash flows to their present value and thus
arrive at the investment's fair value.

You can then compare fair value to its market price. If

your price estimate is higher than the market's, you
could consider the stock a bargain. If your price
estimate is lower, you could consider the stock to be
overvalued
Example
Berjaya Auto has stock valued at $10 per share. It
reliably pays a $1 dividend per share and predicts
its dividend will steadily grow by 5% per year.
The investors required rate of return is 17%.
Solving the equation [P = D1 / (k-g)],
we see that: P = $1 / (.17 - .05) = $8.33
The model says the stock is worth $8.33 -- $1.67 less
than the market price. Thus, the stock may be
overvalued by the market, suggesting an investor
should not purchase the stock.
 Making Stock Selections
Stock selection criteria are methods for selecting a
stock for investment
Sector Analysis - best stock located in a weak sector
will often perform poorly because that sector is out
of favor
Find the stocks excess return (also called alpha).

Alpha = expected return required return

Select stocks with positive alpha values.

Choose the stocks with the largest alpha values.
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 Example
If a capital asset pricing model analysis indicates that the
portfolio should have earned 5% (based on risk,
economic conditions and other factors), but instead
earned only 3%, then the alpha of the portfolio would
be -2%.

Investors would prefer an investment with a high alpha.

Selecting Stocks: An Example

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determine a stocks intrinsic value and assess whether a
particular stock or group of stocks is undervalued or
overvalued at the current market price

The PE ratio gives investors an idea of how much they

are paying for a companys earning power
 PE ratios

The higher the PE, the more investors are paying, and
therefore the more earnings growth they are
expecting.

High PE stocks those with multiples over 20 are

typically young, fast-growing companies
 Price to Book (P/B) ratio

P/B is the ratio of a stocks price to its book value per

share. A stock selling at a high PB ratio, such as 3 or
higher, may represent a popular growth stock with
minimal book value
 Management Issues

This includes various qualitative judgments regarding

the competence of current and prospective company
management, future strategies to increase operations
and market share and issues relating to insider buying

One way to determine if management is doing a good

job is to evaluate the company's return on equity
Avoid companies that have a history of using
accounting gimmicks to inflate profits or have misled
investors in the past.
Assuming risk is an essential part of achieving
investment gains, but the amount of risk undertaken
can be managed and customized to each investor's
time frame, required rate of return and risk tolerance
 Acquiring Securities Long Term Techniques
Buy and Hold Technique
Buy stocks and hold onto it for a number of years as they are entitled
for dividends, price of stock may go up and finally stock split (there
is no guaranttee that stock split may increase the future value of a
stock investment over a long period of time

Dollar Cost Averaging (DCA)

You make equal $ investments at regular time intervals.

Over time, you invest at an average cost.

It also has the advantage of establishing a periodic investment

habit.

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 Acquring Securities Long Term Techniques
Direct Investment Plans
A direct investment plan allows one to purchase shares directly from a
corporation without having to use a brokerage firm

Dividend reinvestment plans (DRIPs)

DRIPs allows one the option to reinvest the cash dividends to purchase
stock of the corporation i.e. choose to reinvest dividends rather than
receiving cash.
 Acquiring Securities Long Term Techniques

These plans enable investors to purchase shares without paying a

commission charge to a brokerage firm.

Also, some corporations even offer their stock at a small discount to

encourage the use of their direct investment and dividend
reinvestment plans.

The dividend reinvestment plan can can take advantage of dollar cost
averaging.
 Acquiring Securities Short term techniques

Buying stock on Margin

This is a speculate technique whereby an investor
borrows part of the money needed to buy a particular
stock
When buying stock on margin, one borrow part of the
money needed to buy a particular stock.
This financial leverage allows one to buy a larger number
of shares of stock.
 Acquiring Securities Short term techniques

Selling Short

Selling stock that has been borrowed from a brokerage

firm and must be replaced at a later date. When one
sell short, one sell today, knowing one must buy or
cover the short transaction at a later date.
 Acquiring Securities Short term techniques

Options
Option is the right to buy or sell a stock at a
predetermined price during a specified period of time

a) Call Option
Sold by a stockholder and gives the purchaser the right
to buy 100 shares of a stock at a guaranteed price
before a specified expiration date
 Acquiring Securities Short term Techniques

Options

b) Put Options
A put option is the right to sell 100 shares of a stock at a
guaranteed price before a specified expiration date.
 Selling Securities
The decision to sell securities is at least as difficult as
the decision to purchase. Some investors believe it is
the hardest decision.
When should an investor sell?
If the security becomes overvalued
Your investment objectives change such as the need for
current income as compared to price appreciation.

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 Conclusion

We must determine the level of risk each of us is

willing to accept.
An understanding of diversification is a must in the
investment world.
Learn to build a portfolio that meets your needs.
Determine when professional help is needed.

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 Tutorial Questions
1) Using examples, how would you explain the risk management
technique of investment diversification

2) Describe the technique of Dollar cost averaging in softening the

impact of fluctuations in the investment market.

3) With an illustration, demonstrate the process of dollar cost

averaging

4) What is the meaning of Buy and Hold technique?

5) Why must investors buy securities on margin?

 Tutorial Questions
6) Which of the following would offer the best return on
investment? Assume that you buy $5,000 in stock in all three
cases, and ignore interest and transaction costs in your
calculations.
a) Buy a stock at $80 without margin, and sell it 1 year later
at $120
b) Buy a stock at $32 with 50% margin, and sell it 1 year
later at $41
c)Buy a stock at $50 with 75% margin, and sell it 1 year
later at $65
7) Identify ways to select stocks of companies so that risk can be
reduced.