TABLE OF CONTENTS. SCHEME OF WORK Learning Outcomes Course Synopsis Teaching Methodology Assessment Teaching Schedule References

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1 BASIC OF INVESTMENT TABLE OF CONTENTS SCHEME OF WORK Learning Outcomes Course Synopsis Teaching Methodology Assessment Teaching Schedule References Page v v v v vi x CHAPTER 1: INTRODUCTION TO FUNDAMENTALS OF INVESTMENT 1.1 Definition of Investment Benefits of Investment Objectives of Investment Required Rate of Return Types of Investment Conclusion 13 CHAPTER 2: RISKS AND RETURNS 2.1 Sources of Returns on Investment Calculating Returns Calculating Expected Returns Reinvestment Risks of Investment Measuring Risks Coefficient of Variation Conclusion 24 i

2 BASIC OF INVESTMENT CHAPTER 3: TIME VALUE OF MONEY 3.1 Concept of Time Value of Money Time Value of Money for a Single Amount Future Value for a Single Amount Present Value for a Single Amount Time Value of Money for Annuity Present Value of Annuity Future Value of Annuity Time Value of Money for Perpetuity Time Value of Money with Adjusted Rate of Return Time Value of Money with Real Rate of Return Conclusion 42 CHAPTER 4: PORTFOLIO THEORY AND ASSET VALUATION MODEL 4.1 Introduction to the Diversification Concept and Portfolio Diversification and Modern Portfolio Theory Efficient Portfolio and Efficient Frontier Conclusion 48 CHAPTER 5: PORTFOLIO MANAGEMENT AND ASSET MANAGEMENT STRATEGIES 5.1 Investment Strategies Basic Investment Strategy 49 a. Long term strategy 50 b. Short term strategy 50 c. Strategy based on economic sector cycle 50 d. Investment hedging strategy Investment Strategies according to Modern Portfolio Theory Conclusion 52 ii

3 BASIC OF INVESTMENT CHAPTER 6: COMPANY S FINANCIAL STATEMENT ANALYSIS 6.1 Introduction to Financial Statement Types of Financial Statements 54 a. Statement of Financial Position 54 b. Income Statement 55 c. Statement of Changes in Equity 55 d. Statement of Cash Flow Financial Statement Analysis 56 a. Comparative Analysis 56 b. Ratio Analysis Limitations of Financial Analysis Conclusion 71 CHAPTER 7: STOCK VALUATION 7.1 Introduction to Stocks and Stock Investment Stock Valuation Estimating a Stock Price Calculating Rate of Return Relative Valuation Conclusion 80 CHAPTER 8: BOND VALUATION 8.1 Introduction to Bonds Bond Value and Results Yield to Maturity (YTM) Bond Rating Government Bonds Conclusion 90 iii

4 BASIC OF INVESTMENT CHAPTER 9: INVESTMENT PERFORMANCE EVALUATION 9.1 Introduction to the Concept of Investment Performance Evaluation Criteria for Portfolio Evaluation The Sharpe Measure Method The Treynor Performance Measure Method The Jensen Performance Measure Method Rebalancing Investment Portfolios Trade-off in the Decision to Rebalance Conclusion 107 REFERENCES: 108 iv

5 BASIC OF INVESTMENT SCHEME OF WORK Programme : Executive Diploma in Accounting Administration Course Code : UESA 1101 Course Title : Basic of Investment Credit Hours : 4 LEARNING OUTCOMES At the end of this course, students should be able to: 1. Discuss the basic principles and theories in the field of investment 2. Identify the risk and return of investment 3. Review the management of portfolio and strategy asset management strategies and also the theories of portfolio 4. Use the knowledge in the setting (location) where the investment manager make decisions 5. Demonstrate understanding of the investment profession ethics and the importance of investment performance evaluation 6. Identify the investment products (based on equity and debt) and unit trusts COURSE SYNOPSIS This course provides students an exposure to the investment theories, investment securities available in the Malaysian capital market and ways to evaluate investment opportunities based on risks and returns. Students will also have the opportunity to carry out a task based on the principles and theories they have learned. TEACHING METHODOLOGY Lecture, group discussion and classroom exercise. ASSESSMENT Continous Assesment 60% Final examination 40% Total 100% v

6 BASIC OF INVESTMENT TEACHING SCHEDULE WEEK TOPIC REFERENCE CHAPTER 1: INTRODUCTION TO FUNDAMENTALS OF INVESTMENT Definition of Investment 1.2 Benefits of Investment 1.3 Objectives of Investment 1.4 Required Rate of Return 1.5 Types of Investment 1.6 Conclusion CHAPTER 2: RISKS AND RETURNS 2.1 Sources of Returns on Investment 2.2 Calculating Returns 2.3 Calculating Expected Returns 2.4 Reinvestment 2.5 Risks of Investment 2.6 Measuring Risks 2.7 Coefficient of Variation 2.8 Conclusion Reference Book, Slide, Lecture Notes. vi

7 BASIC OF INVESTMENT WEEK TOPIC REFERENCE CHAPTER 3: TIME VALUE OF MONEY Concept of Time Value of Money 3.2 Time Value of Money for a Single Amount 3.3 Time Value of Money for Annuity 3.4 Time Value of Money for Perpetuity 3.5 Time Value of Money with Adjusted Rate of Return 3.6 Time Value of Money with Real Rate of Return 3.7 Conclusion Reference Book, Slide, Lecture Notes. CHAPTER 4: PORTFOLIO THEORY AND ASSET VALUATION MODEL Introduction to the Diversification Concept and Portfolio 4.2 Diversification and Modern Portfolio Theory 4.3 Efficient Portfolio and Efficient Frontier 4.4 Conclusion CHAPTER 5: PORTFOLIO MANAGEMENT AND ASSET MANAGEMENT STRATEGIES Reference Book, Slide, Lecture Notes. 5.1 Investment Strategies 5.2 Investment Strategies according to Modern Portfolio Theory 5.3 Conclusion vii

8 BASIC OF INVESTMENT SAEMBUDAYAAN USAHAWAN WEEK TOPIC REFERENCE CHAPTER 6: COMPANY S FINANCIAL STATEMENT ANALYSIS Introduction to Financial Statement 6.2 Types of Financial Statements 6.3 Financial Statement Analysis 6.4 Limitations of Financial Analysis 6.5 Conclusion Reference Book, Slide, Lecture Notes. CHAPTER 7: STOCK VALUATION Introduction to Stocks and Stock Investment 7.2 Stock Valuation 7.3 Estimating a Stock Price 7.4 Calculating Rate of Return 7.5 Relative Valuation 7.6 Conclusion Reference Book, Slide, Lecture Notes. ASAS PEMBU USAH AWAN viii

9 BASIC OF INVESTMENT WEEK TOPIC REFERENCE 6 CHAPTER 8: BOND VALUATION 8.1 Introduction to Bonds 8.2 Bond Value and Results 8.3 Yield to Maturity (YTM) 8.4 Bond Rating 8.5 Government Bonds 8.6 Conclusion Reference Book, Slide, Lecture Notes. CHAPTER 9: INVESTMENT PERFORMANCE EVALUATION Introduction to the Concept of Investment Performance Evaluation 9.2 Criteria for Portfolio Evaluation 9.3 Rebalancing Investment Portfolios 9.4 Trade-off in the Decision to Rebalance 9.5 Conclusion Reference Book, Internet, LCD powerpoint ix

10 BASIC OF INVESTMENT REFERENCES 1. Avadhani, V.A.. Securities Analysis and Portfolio Management, Global Media, Mumbai, India, Kamarulzaman Bakri, Analisis, Proses Dan Strategi Portfolio Pelaburan Berteraskan Syariah, Universiti Utara Malaysia, Mei Reilly & Brown, The Investment Setting, Investment Analysis and Portfolio Management, Thomson South Western, 8 th Edition, Ross, Westerfield and Jordan, Fundamentals of Corporate Finance, McGraw Hill, 6 th Edition, Yesim Tokat, Portfolio Rebalancing in Theory and Practice, Vanguard Investment Counseling & Research towering skills.com x

11 CHAPTER 1 INTRODUCTION TO BASIC OF INVESTMENT Learning Objectives At the end of this chapter, students should be able to: 1. Explain the definition of investment 2. Understand the benefits of investment 3. Explain the objectives of investment 4. Identify the required rate of return 5. Differentiate the types of investment 1.1 Definition of Investment Investment is defined as today s financial commitment for a period of time with the purpose of obtaining returns in the future. Investors may consist of individuals, governments, pension funds or corporates. This definition covers all types of investment, whether corporate investment in machinery and equipment, or individual investment in listed stocks, bonds and commodities. In all cases, investors convert a present amount of money in which the total is known with an amount of cash flow that is expected to be higher in the future in comparison to the initial investment. This answers the question of why individuals invest and what they want from their investment. Individuals invest their money in order to reap the rewards for their time commitment, expected inflation and uncertainties of returns. The rewards are known as returns, whereas the uncertainties are called risks. 1

12 Investment is an instrument to generate and accumulate wealth. In the financial management process, investment is a significant instrument in order to ensure that the individual s financial goal is achieved. Imagine if Mr. A wishes to perform hajj in five years, but he does not invest his money and instead only keeps his money at home. Although he diligently saves every month, will he be able to achieve his goal? The answer, maybe yes and maybe no. 1.2 Benefits of Investment a. Investment Restricts Negative Effect Of Inflation On Value of Money He may be able to perform hajj in five years if the amount he saves increases every year. This is because the cost of performing hajj, as well as the cost of other goods and services, increases each year due to inflation. If the amount he saves is the same every year, he may be forced to postpone his journey to Mecca as he has to wait to attain sufficient savings. It is also provided that the government subsidises the cost of hajj in order to ensure that it does not increase. However, what about other costs that are always increasing? The simulation below shows the effect of inflation on the cost of hajj. The cost of hajj below is the actual cost imposed on pilgrims in years after Tabung Haji provided subsidy of more than RM2,000 every year to each pilgrim. If Mr. A sets to save an amount of RM2,000 each year in order to attain a total of RM10,000 in five years, will his wish be fulfilled if the cost of hajj increases further in the next year? 2

13 Diagram 1.1: Fixed Savings of Hajj in comparison to the Cost of Hajj Investment is able to restrict the negative effect of inflation on the purchasing power of money because by investing, we have the potential to generate returns on the investment. For example, if Mr. A deposits his money into Tabung Haji, the money will be accumulated to be invested in plantation, real estate, trade and other activities. The product of these investments enable Tabung Haji to pay dividend to its depositors. The dividend given by Tabung Haji is able to reduce the collapse of the individual s purchasing power of money as a result of inflation. The simulation in Table 1.1 displays the total savings of Mr. A, assuming that Tabung Haji provides a 5% dividend each year. The total savings of Mr. A will increase to RM11,604 at the end of year 5. If the cost of hajj is fixed at RM9,980, the remaining savings allow Mr. A to use it for other necessities. 3

14 Table 1.1: Simulation of Total Savings with a 5% Yearly Dividend Year Beginning balance , , , , Savings 2, , , , , Balance 2, , , , , Dividend Ending balance 2, , , , , b. Investment Helps Prepare For Future Financial Needs Investment helps prepare for future financial needs. As in the previous example, investment helps Mr. A to attain his goal of performing hajj and at the same time provide extra money for other uses. The life of a human has a cycle from childhood to adulthood which include career, marriage and retirement. Each stage of life requires different needs. At the time of retirement for example, life necessities increase in terms of medical needs, comfortable home and healthy food. Imagine if we only have an EPF savings of less than RM50,000 by the time we retire. This amount is indeed not sufficient to sustain life in retirement. If we assume that only RM1,000 is needed each month, the savings will be used up in 4 years and 2 months only! This did not take into account the effect of inflation on our expenses. If we have to maintain the amount of payment for fixed costs such as groceries and utility bills, with inflation, our savings will be exhausted within a shorter period. Therefore, we must take immediate steps in preparing an investment plan to ensure that future needs are met. 4

15 1.3 Objectives of Investment Investment, in general, involves commitment of funds to the assets which will be held for a long period of time. Investors (as opposed to speculators) usually have a time limit which exceeds six months or a year. In making a decision to invest money for a long period of time, investors hope to acquire a reasonable return of investment. This return must provide compensation for investors for:- a. The length of time the money is invested b. Expected inflation c. Uncertainty of future returns a. The length of time the money is invested Investors would certainly want returns as compensation for their commitment. In making a decision to choose an investment product, investors indeed face several options such as whether to invest in unit trusts, listed stocks or even real estate investment trusts. Or perhaps, the easiest and lowest in risk is to deposit at Tabung Haji which can provide at least a 5% yearly return. Therefore, if investors opt for unit trust for example, investors would surely expect to acquire a return that is at least equal to the return which may have been acquired from depositing at Tabung Haji. This is known as opportunity cost. Opportunity cost is one of the determining factors of the expected rate of return that investors want. b. Expected inflation Inflation is the rate of price increase. It is measured by comparing present price with previous price. Inflation causes the value of money to decrease. In other words, inflation causes the purchasing power of money to fall. Imagine if 30 years ago, with 20 cents, we were able to buy food and drinks for lunch at the school canteen. However, with 20 cents now, we can only buy 2 pieces of candy. 20 cents will not able to buy us a plate of noodles, even a piece of cake, today. Such are the effects of inflation. 5

16 The official inflation rate recorded by Bank Negara Malaysia (BNM) is 4% per annum. With this rate, in 16 years, the value of money will decrease by 50%. This means, RM1,000 that we own today, will only be worth RM years from now. In 32 years, it will only have a value similar to RM250 today. Inflation is said to be the main enemy of money, besides taxes. Taxes, which come in many forms such as income tax, road tax and sales tax, is especially understood to be the erosive factor of money. Nevertheless income tax for example, affects us only if we have an income which exceeds a certain level. This is also the case with road tax, which impacts only those possessing vehicles. Sales tax can also be avoided by not buying goods which impose tax. However, it is different with inflation whereby it affects all, regardless of the level of income or lifestyle. It is important to mention that the higher the lifestyle, the higher the personal inflation rate. This is because luxury goods have a higher inflation rate in comparison to normal goods. For that reason, it is smarter to choose goods based on its usability and quality, rather than brand. Another reason why inflation is the main enemy of money is due to its snow ball effect. Compounded inflation rate causes the value of money to further decrease. As mentioned above, in 16 years, the value of money will decrease by 50% and in 32 years, the value of money will fall by 75%! The understanding on inflation and its impact on the value of money is very important to ensure that the purchasing power of money is not affected. An easy way is to ensure that our return on investment is higher than the inflation rate. In order to achieve this goal, we must understand the types of investment, risks of the investment and methods to manage it. c. Uncertainty of future returns Investment is often associated with risk. Risk means that the investment may provide returns which differ from what we expect. In certain cases, we can lose all our investment money. For that reason, investors always hope to acquire returns which correspond to the risk taken. The higher the risk, the higher the expected rate of return. 6

17 This explains the concept of risk and return trade-off. Investors are usually risk avoiders. If they are forced to face a high risk in their investment, they would also expect a high return. Therefore, product suppliers or operators should also provide high returns for a high-risk product with the purpose of attracting many people to invest in the product. Another way to explain the concept of risk and return trade-off is to view investment products which depend on the supply and demand factor such as the listed shares on Bursa Malaysia. Some listed shares or stocks have a high volatility. This means that the potential to gain a high return on capital from this share is great. However, keep in mind, share price which has the potential to rise higher has also the same potential to fall badly. Therefore, the higher the return, the bigger the risk! 1.4 Required Rate of Return The definition of investment means that investors require a minimum rate of return on their investment, and investments will only be made if investors are confident in acquiring returns that exceed this rate. In the field of investment, this rate is termed required rate of return. Investors need to acquire minimum returns as compensation for their sacrifice: (1) separating from their money, (2) facing decline of value of money (inflation), and (3) bearing the risk of uncertain returns which will be acquired later. Therefore, in theory the required rate of return comprises the following three elements: Real rate of return, r Inflation rate, i Rate for the risks faced (risk premium, rp) 7

18 Element 1: Real rate of return Real rate of return is compensation for the sacrifice of assets; i.e. the duration in which the investors part from their money. It is also a reward for postponing the use of the money until the future. The real rate of return is also considered as the rate of return for all investments in the absence of inflation and risk. Element 2: Inflation protection As discussed earlier in this chapter, inflation is the increase of general price level of goods. When inflation occurs, purchasing power of money will decline. If the value of money declines in the future due to inflation, we require a compensation to protect ourselves from this loss. This is called inflation protection. What is the relationship between the real rate of return and inflation rate? In investment, the real rate of return can be interpreted as real interest rate. Interest rate is the rate of return on risk-free assets, such as bond. Market interest rate is called nominal rate, nr, and it covers (1) real interest rate, and (2) expected inflation rate. Its simple formula: nr = r + i Whereby: nr = nominal rate r = real rate i = inflation rate. 8

19 Element 3: Compensation for bearing risk Risk in investment is the uncertainty of returns to be acquired. Investors in general are risk avoiders. Nevertheless, risks cannot be evaded in investment. Therefore, investors must be given compensation that is appropriate with the risks they bear. For investments with no risks, a reasonable return is similar to risk-free nominal interest rate. If the investment is risky, investors require returns which exceed the risk-free rate as a premium for risk. In conclusion, the rate of return required by investors is a mixture of (1) real rate of return, (2) inflation and (3) risk premium. The risk premium vary according to how low or high the risk of an investment is. The higher the risk, the higher the risk premium that is required. As a formula, the required rate of return can be written as follows: k = r + i + rp (r + i) is also stated as rate of return without risk or risk-free rate, k rf. Hence, the rate of return can be rewritten as follows: k = k rf + rp 9

20 1.5 Types of Investment There are several types of investment in the market. They consist of physical assets, financial assets, derivative assets and alternative assets Physical assets Physical assets are when investors invest their money in physical assets such as lands, houses, office buildings, factory buildings, machinery and equipment as well as stocks. What are the risk factors which should be considered in physical investments? Long term capital returns Fairly fixed but uncertain cash flow Repair costs Low liquidity Financial assets Financial assets are when investors invest their money in financial instruments which can be used as claims on the value which they have invested. Examples of financial assets are shares, bonds and trust units. a. Shares Investment in the shares of a company is a direct investment in which investors invest their money by buying the company s shares. The money invested by investors will be used by the company to finance its business operations. As a reward, investors may acquire returns resulting from the company s profits. Two forms of returns from share investment are: i. Cash flow from distribution of profit which is known as dividend ii. Capital gain when the shares are resold to the market 10

21 Investors of share investment are also entitled to attend the company s Annual General Meeting and to cast their votes in the meeting. In other words, by owning the shares of the company, investors actually have the right to make decisions in the company. Share investment, however, has its own risks. Among the risks of share investment are: i. Price which may fluctuate drastically due to changes in the economy, politics and natural disasters ii. Companies which may suffer losses and were delisted iii. Mismanagement which may cause companies to be suspended from the list iv. Low liquidity due to low demand b. Bonds Bonds are debt instruments issued by governments or companies to acquire money to finance the operations of major projects. Bond investors are creditors of bond issuers whereby every six months or every year bond issuers will pay interest to bond holders. Bond investment is only open to major investors as each bond unit costs more than RM1 million. Bond investment provides fixed returns to investors. The risk of bond investment depends on the types of bond. Company bonds are considered a higher risk in comparison to government bonds. The risk of bond investment lies in the failure of the bond issuers to pay the pledged interest at each term and in more severe cases, the failure to reimburse the principal sum of the investment. 11

22 c. Unit trust Unit trust is a fund which accumulates the money of many investors with similar goals to be invested in financial markets such as stock market, bond market and short term money market such as Negotiable Certificate of Deposit, Treasury Bill, Banker s Acceptance, etc. Unit trust investment enables investors to reap dividend returns and capital gains from proceeds of reselling of all units which may increase in price. Advantages of investing in unit trusts are: i. Funds are managed by professional managers ii. Higher level of liquidity compared to direct investment in shares iii. Provides diversification benefits, i.e. lower risk compared to direct investment iv. Provides an opportunity for small investors to gain exposure to assets which are not individually affordable, such as bonds and sukuk. Conversely, disadvantages of investing in unit trusts are: i. Investors do not have the right to make decisions ii. Sales and management costs which are relatively higher if compared to direct investment in stock markets iii. Diversification lowers risks and at the same time reduces returns Derivative assets Derivative assets are assets in which its value is acquired from its underlying assets. The most common form of derivative assets are futures contracts and options contracts. An example of derivative asset in Malaysia is Future Crude Palm Oil. For this asset, its value depends on the price of crude palm oil in the market. 12

23 Derivative assets pose a higher risk in comparison to other financial assets. This is because the asset trade is done in advance based on a price which is expected in the future. The risk is higher when the asset purchase is made using money loans Alternative assets Alternative assets are gold, silver, paintings, antiques, etc. These assets are usually personal collections and are only when the need arises. 1.6 Conclusion Investment is a very significant activity in financial management. Its goal is to acquire returns as a reward for the sacrifice of investors in postponing its use, expected inflation and uncertainty of obtaining the returns. The skill of choosing a suitable asset is highly important to ensure investors gain the desired benefits from the investment. 13

24 CHAPTER 2 RISKS AND RETURNS Learning Objectives: At the end of this chapter, you are able to: 1. Identify the sources of returns on investment 2. Understand the method of calculating returns 3. Understand how to calculate expected returns 4. Appreciate the importance of reinvestment 5. Explain the meaning of risk in investment 6. Identify risk measurement methods 7. Understand the use of coefficient of variation in investment decision making he meaning of asset, liability and owner s equity 2.1 Sources of Returns on Investment As discussed previously, returns on an investment consist of two parts: a. Return on revenue These returns are cash inflows from the investment to investors. It is the distribution of profit which is known as dividend, profit and bonus or may also be service charge such as rent and fees. Examples of return on revenue i. Ahmad purchases a TNB share with the price of RM10.00 per share. In a year, TNB pays a 30 cents dividend for each share. Return on revenue = 0.30/10.00 = 0.03 = 3.0% ii. Hamid buys a house with the price of RM200,000 to be rented. The net annual rent income is RM10,000. Return on revenue = 10,000/200,000 = 0.05 = 5% per year. 14

25 b. Return on capital Return on capital is the return on proceeds of reselling the investment. It is obtained through the changes in price of the asset. If the price of investment increases compared to the purchase price, investors will make a profit. If the price decreases, investors will incur a loss. Examples of calculation for return on capital i. Ahmad purchases a TNB share with the price of RM10.00 per share. In a year, the TNB share price increases to RM Capital gain = ( )/10.00 = 0.12 = 12% ii. Hamid buys a house with price of RM200,000 to be rented. After five years, the house is sold with the price of 260,000. Capital gain=(260, ,000)/200,000 = 0.30 = 30% for five years. 2.2 Calculating Returns Return on Money (Ringgit) The amount of money earned from investment for a specific period Return on Ringgit = Income + Price Difference Depends on the size of investment and the holding period (investment) Holding Period Return (%) Calculated as percentage of Return on Money (RM) compared to total investment Can be used to compare the performance of investments provided that the holding period and risk are the same Rate of Return = Income + (Selling Price-Purchase Price) Purchase Price 15

26 2.2.3 Return per Year (or Annual) In most cases pertaining to return on investment, we usually call it in the form of rate of return per year or annual rate of return By calculating the annual return on investment, we can compare the performance of any investments which are calculated using the same method. A simple method (or approximate) of converting the Holding Period Return (PTP) to Annual rate of Return (PT): PT = PTP x number of period per year (n) Examples: Holding period return of 6 months is 8%. Therefore, return per year is: 8% x 2 = 16% Holding period return of 3 months is 2.5%. Return per year is: 2.5% x 4 = 10% Holding period return of three years is 36%. Return per year is: 36% x 1/3 = 12% The exact method: PT = (1+PTP) 1/n Calculating Expected Returns Expected returns can be calculated by measuring the average rate of return for real returns over several past periods. The average return is usually used to anticipate the rate of return which is the most likely to be achieved by an investment in the future. It is the easiest method to acquire the expected rate of return for an investment. Let s look at the table below, if our investment produces the following annual returns. What is our average rate of return? 16

27 Year Rate of Return % % % % % There are two methods of calculating the average return: Arithmetic Mean Geometric Mean Arithmetic Mean Return Arithmetic mean return is the simple average return for a given series of returns. We only total all returns and divide by the number of years: P a = (PTP)/t From the above example: P a = 40/5 = 8% The average rate of return is 8%. Is the calculation accurate? Actually, it is not. If we acquire this rate of return annually, the amount of money earned is not the same as the actual total. Table 2.3 (a) below shows the initial investment total of RM1,0000 increasing to become RM1,372 when given returns such as the previous example. 17

28 Table 2.3 (a): Total investment with real rate of return Year Beginning Balance (RM) Rate of Return Return (RM) Ending Balance (RM) 1 1, % , , % , , % , , % , , % , If we use an average rate of 8%, the amount of money earned in year 5 is not the same as the real amount. Table 2.3 (b) displays the total investment after 5 years at the average rate of 8%. Table 2.3 (b): Total investment with average rate of return of 8% Year Beginning Balance (RM) Rate of Return Return (RM) Ending Balance (RM) 1 1, % , , % , , % , , % , , % , An accurate method is to calculate the Geometric Mean Return Geometric Mean Return Geometric mean return will provide a total return which is exact to the value of money earned from the investment: 18

29 It is calculated according to the following formula: P g = [Л(1+PTP)] 1/n 1 = [(1.10)(1.30)(.80)(1.00)(1.20)] 1/5 1 =.0654 or 6.54% Now let s look at the total investment after 5 years using the geometric mean return. Notice that the total investment in the fifth year is equal to the total investment based on the annual real rate of return. Table 2.3 (c): Total investment with average rate of return of 6.54% Year Beginning Balance (RM) Rate of Return Return (RM) Ending Balance (RM) 1 1, % , , % , , % , , % , , % , Reinvestment Notice that in the previous examples, calculation is made by assuming investors reinvest the returns earned from the investment. This method is called compounded method whereby returns in the first year will be reinvested to be the principal value or the principal for the second year increases with the total returns earned in the first year. In other words, we do not remove it from our investment system. With reinvestment practices, the value of investment increases faster. Try to compare the total investment accumulated after 5 years with reinvestment (Table 2.4 (a)) and without reinvestment (Table 2.4(b)). Assume that the initial investment is RM50,000 and the average rate of return is 8%. 19

30 Notice that with reinvestment, the total investment increases to RM73,466. Whereas assuming that the investor withdraws all of the earned returns, the total investment remains RM50,000 after 5 years. Table2.4 (a): Total investment with reinvestment of returns Year Beginning Balance (RM) Rate of Return Return (RM) Ending Balance (RM) 1 50, % 4, , , % 4, , , % 4, , , % 5, , , % 5, , Table 2.4 (b): Total investment without reinvestment of returns Year Beginning Balance Rate of Return Return (RM) Withdrawal (RM) Ending Balance (RM) (RM) 1 50, % 4, , , , % 4, , , , % 4, , , , % 4, , , , % 4, , , Risks of Investment Risks are the uncertainties pertaining to the return on investment. When investing, we have an expectation on the return. This expectation may be accurate; it may also not be (usually not accurate). These uncertainties in acquiring the expected return is called risks in investment. 20

31 In investment, uncertainties occur in three situations: Uncertainty in return on revenue Uncertainty in investment price change Uncertainty in rate of reinvestment Risks can be divided into two types: (1) systematic risk and (2) unsystematic risk. Both risks stem from different factors. Systematic risks are risks which are caused by factors of economy, politics and natural disasters, whereby its occurrence gives an impact to the overall market. For example: changes in interest rate, inflation, national production, political crisis, tsunami, etc. Unsystematic risks are risks which are limited to specific companies, types of product or industries. Examples of unsystematic risks are the fluctuation in product demand, management misconduct, changes in policy pertaining to a product, etc. 2.6 Measuring Risks As explained earlier in this chapter, the risk of investment is the possibility that the earned returns are not the same as the expected returns. We have also learned how the expected return is calculated based on the real returns which were recorded over several years. As investments are made in order to earn future returns, it is reasonable that probable returns are also considered in order to obtain the expected return. For expected returns which are made based on past records of real returns, the distance between the real returns and the average returns can reveal the rate of investment risk. Compare the assets of investment A and B shown in Table 2.6. At random, what can you say about both of these assets? 21

32 Table 2.6: Real return of Asset A and Asset B Year Asset A Asset B % 20.00% % 30.00% % -5.00% % 15.00% % 40.00% Based on the average return formula discussed previously, the average return or expected return for Asset A and Asset B are as follows: P g Asset A = [Л(1+PTP)] 1/n 1 = [(1.08)(1.09)(1.07)(1.08)(1.10)] 1/5 1 = or 8.40% P g Asset B = [Л(1+PTP)] 1/n 1 = [(1.20)(1.30)(0.95)(1.15)(1.40)] 1/5 1 = or 19.00% Investment risks are calculated by considering the distance between the real returns and the expected returns of the investment. The distances are then squared and totalled in order to obtain the total distance or variance. The standard measure for risk is standard deviation which is the square root of the variance. In other words, standard deviation is the average distance between the distribution of real returns and expected returns of the investment. 22

33 The formula for variance is: whereby: 2 = [Σ(R i -E(R)) 2 ]/(n-1) R i = probable value, E(R) = expected value, n = number of probable value Therefore, the variance and standard deviation for Asset A E(R) = 8.40% 2 = [( ) 2 +( ) 2 +( ) 2 +( ) 2 +( ) 2 ]/(5-1) = [0.0016% % % % %]/(5-1) = % = 1.14% The variance and standard deviation for Asset B E(R) = 19.00% 2 = [( ) 2 +( ) 2 +( ) 2 +( ) 2 +( ) 2 ]/(5-1) = [0.0101% % % % %]/(5-1) = % = 16.99% Notice that asset B has a higher expected return than A, and also pose a higher risk than A. It is clear that the law of risk and return trade-off is proven the higher the return, the higher the risk. 23

34 Therefore, how do investors choose between these two assets? If investors choose a high return, obviously they should opt for B. However, B has a very high risk compared to A. If investors prefer low risk, they should then choose A. However, A provides a very low return. What is the solution? 2.7 Coefficient of Variation Coefficient of variation measures risks for each unit of return. This means that for each 1% of return, what is the risk of the asset. This measurement enables investors to choose their investments, such as the example above, between Asset A and Asset B. The formula for coefficient of variation is: CV = / E(R) Therefore, the Coefficient of Variation for asset A and B are as follows: CV Asset A = 1.14%/8.40% = 13.58% CV Asset B = 16.99%/19.00% = 89.45% Notice that Asset A has a risk of 13.58% for every 1% of its return, whereas Asset B has a risk of 89.45% for every 1% of its return. Investors who are rationally risk avoiders will definitely choose Asset A as it has a lower risk than Asset B. 2.8 Conclusion Risks and returns are the most important concepts which investors need to understand. Investors must be skilled in the method of calculating returns to ensure the goal of investment is achieved. The risk-return relationship requires investors to understand how to balance between risk and return to ensure the investments made produce optimum returns. 24

35 Activity 1: Calculate the return on revenue based on the information given: 1. Ali buys 10,000 ASN units with the price of RM0.70 per unit. At the end of the year, ASN gives a dividend of 5.6 cents per unit. 2. Ah Peng buys a Public Bank share with the price of RM12.50 per share. The annual dividend is 25 cents per share. 3. Muthu buys a land lot with the price of RM80,000. He expects to sell it in three years with the price of RM120,000. The land now is turned into a car park and generates an average income of RM400 per month. Activity 2: Calculate the return on capital for the following investments 1. Ali buys 10,000 ASN units with the price of RM0.70 per unit. At the end of the year, the price of ASN has increased to RM0.74 per unit. 2. Ah Peng buys a Public Bank share with the price of RM12.50 per share. After a year, the price share is RM10.00 per share. 3. Muthu buys a land lot with the price of RM80,000. After three years, he sells it with the price of RM110,

36 CHAPTER 3 TIME VALUE OF MONEY Learning Objectives: At the end of this chapter, you are able to: 1. Explain the concept of time value of money 2. Calculate the time value of money for a single amount 3. Calculate the time value of money for a cash flow or annuity 4. Calculate the time value of money for an infinity or perpetuity cash flow 5. Calculate the time value of money for adjusted rate of return 3.1 The Concept of Time Value of Money Time value of money is the most basic principle of financial and investment knowledge. Time value of money states that the value of an amount of money today is higher than the same amount of money to be acquired in the future. This is due to its ability to generate income if used for investment. If it is not used for investment, and instead used for purchases, the satisfaction it gives today is higher than the satisfaction gained if the same amount of money is spent in the future. One of the reasons is the factor of inflation which causes the amount of goods obtained in the future to not be as much as the amount obtained today. This causes today s value of money to be higher than the value of the same amount of money in the future. The principle of time value of money makes a rational individual to not accept the same amount of money in the future, unless he is rewarded with an appropriate compensation. 26

37 As discussed in the previous chapter, an appropriate compensation means returns which can equal: Opportunity cost: profit which can be earned if the money is invested Inflation: the occurring increase in the price of goods Credit risk: the possibility the money is not paid 3.2 Time Value of Money for a Single Amount If we invest RM10,000 in an investment instrument which can give us a 7% return per year, what is the future time value of money after 10 years? Or, if we would like to obtain a total of RM100,000 in five years, what is the amount that we need to invest today if the investment can provide a 6% return? Both of these questions are concerned with time value of money for a single amount. A single amount means an amount that we need to invest today without increasing our investment. Or an amount which we will obtain only once in the future, such as EPF savings which we will withdraw at the age of 55. Time value of money is divided into two: future value and present value. Future value is acquired using compounding method whereas present value uses discounting method. To understand the meaning of compounding and discounting methods, we need to look at Diagram 3.2: 27

38 Diagram 3.2: Compounding and Discounting Discounting and Compounding Compounding Future value -RM1000 RM1500 RM2000 RM Present value Discounting Diagram 3.2 shows that in order to obtain future value in year 3 for an RM1,000 that is invested today, the RM1,000 needs to be compounded at a certain profit rate for a specific duration Future Value for a Single Amount As explained previously, the future value for a single amount is the value of an amount of money which we invest today at a certain profit rate for a specific duration. Let s look at this example: What is the accumulated value if we invest RM10,000 today for a period of 10 years, assuming that the investment can provide a 7% return. Its basic formula is: n FV = PV x (1 + r) 28

39 Whereby: FV = future value PV = present value r = profit rate n = period in number of years Therefore, when RM10,000 is invested at the rate of 7% for a period of 10 years, the future value is: FV = 10,000 x (1+0.07) 10 = 10,000 x = 19,672 If we want a higher future amount, what can we do with the same amount of money today? In other words, if we feel that RM19,672 is not sufficient, what are the ways so that the RM10,000 that we own today will increase to a higher amount? The answer, with the same present value, the future value can be increased by: Acquiring a higher profit rate Obtaining an investment instrument which makes profit distribution more frequent (More frequent compounding) Investing for a longer period Acquire a higher profit rate Example: r = 12% In comparison to the previous example in which the profit earned is 7%, we can increase the future value by obtaining a higher return, which is 12%. 29

40 r 7% 12% FV = 10,000 x (1+0.07) 10 = 10,000 x (1+0.12) 10 = 10,000 x = 10,000 x = 19,672 = 31,058 Obtain an investment instrument which has more frequent profit distribution (More frequent compounding) Example: twice a year, hence n = 10 x 2 = 20 r = 7 %/2 = 3.5% When profit is distributed more frequently, specifically twice a year, the future value becomes higher, i.e. RM19, 898, compared to RM19, 672 which was obtained previously. Frequency Once a year Twice a year FV = 10,000 x (1+0.07) 10 = 10,000 x ( ) 20 = 10,000 x = 10,000 x = 19,672 = 19,898 Invest for a longer period Example: n = 15 In comparison to an earlier example, when the period of investment is extended to 15 years, the future value increases to RM27,590. n FV = 10,000 x (1+0.07) 10 = 10,000 x (1+0.07) 15 = 10,000 x = 10,000 x = 19,672 = 27,590 30

41 3.2.2 Present Value for a Single Amount The present value is today s value for an amount to be received or paid in the future. As in the second example above, we want to know the present value for an amount of money, i.e. RM100,000 which we expect to receive after five years if the investment we choose can provide a 6% return. Its basic formula is: Whereby: PV = FV = future value PV = present value r = profit rate FV n (1 + r) n = period in number of years Therefore, to acquire RM100,000 in five years, assuming that the rate of return is 6%, the amount which we need to invest today is: PV = 100,000 / (1+0.06) 5 = 100,000 / = 74,727 We may think that RM74,727 is still too high for us to invest today in order to earn RM100,000 five years from now. What is a way so that we do not need to invest a lot of money, but is still able to earn RM100,000? Similar to future value, we can also determine the amount that we need to invest today without changing the amount we expect in the future. However, if for future value we expect a higher amount, for present value, a rational investor usually expects a lower amount. 31

42 Of course, if given the choice, we would like a lower present value of investment to earn a similar future value. The way is similar to the method of obtaining a high future value. In order to acquire a low present value, we need to: Acquire a higher profit rate Obtain an instrument which makes profit distribution more frequent (More frequent compounding) Invest for a longer period we may have to postpone the desire to earn the amount in five years Acquire a higher profit rate Example: r = 11% r 6% 11% PV = 100,000 / (1+0.06) 5 = 100,000 / (1+0.11) 5 = 100,000 / = 100,000 / = 74,727 = 59,344 Obtain an instrument which has a more frequent profit distribution (More frequent compounding) Example: twelve times a year, hence n = 5 x 12 = 60 r = 6 %/12 = 0.5% Frequency Once a year Twelve times a year FV = 100,000 / (1+0.06) 5 = 100,000 / ( ) 60 = 100,000 / = 100,000 / = 74,727 = 74,139 32

43 Invest for a longer period Example: n = 10 n 5 10 FV = 100,000 / (1+0.06) 5 = 100,000 / (1+0.06) 10 = 100,000 / = 100,000 / = 74,727 = 55, Time Value of Money for Annuity If earlier we have learned the method of calculating the time value of money for a single amount, now we will learn the time value of money for a repeated value. The same value of money which is repeated or received /paid regularly is called annuity. In other words, annuity involves more than a single amount. For example, how much is to be invested today in order to earn RM1,000 each year for the next five years if the investment asset provides a 6% annual return? Or, what is the amount to be accumulated in another 15 years if RM1,000 is invested each month in a trust fund which provides an average return of 12% per year? The same amount (RM1,000) which will be received or invested for each period is known as annuity, which is a similar and regular cash flow Present Value of Annuity The present value for an annuity (PVA) of RM1,000 which is to be received at the end of the first until the fifth year, can be determined through discounting the amounts separately, at a given rate of return: 33

44 PVA = [RM1,000 / (1.06) 1 ] + [ RM1,000 / (1.06) 2 ]+ [RM1,000 / (1.06) 3 ] + [ RM1,000 / (1.06) 4 ]+ [RM1,000 / (1.06) 5 ] = RM RM RM RM RM = RM4, For a clearer picture, Diagram 3.3 shows the process of discounting cash flows separately as explained above. Diagram 3.3: Process of discounting cash flows separately NOW Year 1 Year 2 Year 3 Year 4 Year 5 The basic formula for annuity is as follow: PVA = PMT [ 1 ] r (1 + r) n 34

45 Whereby: PVA = present value of annuity PMT = annuity r = profit rate n = period in number of years As it would be a rather complicated calculation for us to use the mathematical approach, it is more practical to calculate annuity using a financial calculator. Here, the calculator used is Casio FC100V. SET END n = 5 r = 6 PV = SOLVE PMT = Future Value of Annuity The future value of annuity is the opposite of the concept of present value of annuity. The future value of an annuity (FVA) can be determined by compounding payments separately. For example, the future value for an annual investment of RM6,000 made at the end of the year for four years in an investment fund which provides an average return of 10% can be illustrated as follows: FVA = [RM6,000 x (1.10) 3 ] + [ RM6,000 x (1.10) 2 ]+ [RM6,000 x (1.10) 1 ] + [RM6,000 x (1.10) 0 ] = RM7, RM7, RM6, RM6,000 = RM27,

46 NOW Year 1 Year 2 Year 3 Using a financial calculator: SET END n = 4 r = 10 PMV = PMT = SOLVE Time Value of Money for Perpetuity If previously we have learned how to calculate time value of annuity, now we will learn what is perpetuity and the method of calculation. Like annuity, perpetuity is also a similar and regular cash flow. What differentiates it from annuity is that annuity has a specific period, whereas perpetuity is an infinity or eternal cash flow. 36

47 Why do we need infinity cash flow? In financial planning, the needs of human beings differ. Some individuals have their own reasons on why they require an infinity cash flow. Among them are: Has a dependent which require continued financial provision, such as a special child. Intends to establish a fund for welfare needs on an ongoing basis In Islamic financial planning, the practice of waqf is highly encouraged especially for those who possess extra money. To establish waqf, especially a private waqf, a person has to know the amount of present value which he needs to establish as the principal amount in order to gain a continuous cash flow or dividend. Its basic formula: PV = PMT/ r Whereby: PV = present value PMT = annuity r = profit rate Example: If Mr. Amin wants the income he receives after retirement to continue (as he is worried that his remaining life will exceed 20 years) and wants his son to continue to receive the income after his demise, Mr. Amin needs to use the present value of perpetuity method to calculate the capital needed at the time of retirement. 37

48 Required income = RM48,000 Expected rate of return = 5% Present value of Perpetuity = PMT r = RM48, = RM960,000 This means that, in order to obtain a continuous cash flow of RM48,000 per year, Mr. Amin needs to have RM960,000 at the time of his retirement and place that money in an investment instrument which can provide him with an annual return of 5%. 3.5 Time Value of Money with Adjusted Rate of Return The method of calculating the time value of money with adjusted rate of return is used to calculate the future value of investment which increases at a certain rate. Its basic formula: n n FV = A((1+r) -(1+g) /(r-g)) Whereby: FV = future value A = annuity or total contribution/investment on regular basis r = profit rate n g = = period in number of years growth rate 38

49 Example: Mr. Suhaimi is 37 years old. The ending balance of Mr. Suhaimi s EPF account is RM100,000. At this time, Mr. Suhaimi s total contribution is RM13,800 per year. What is the expected amount of money in his EPF at the time of retirement if Mr. Suhaimi s income increases at the rate of 7% and the rate of return is 5%? Future value for savings balance Set : End N = = 18 I% = 5 PV = FV = SOLVE 240, Future value of yearly contributions A((1+r) n -(1+g) n )/(r-g) = 13800((1+0.05) 18 -(1+0.07) 18 )/( ) = 13800( )/(-0.02) = /(-0.02) = 671,577 Total EPF savings at the time of retirement = 240, ,577 = 912, Using FC100V to calculate the future value of yearly contributions 39

50 First step: Find the present value of yearly contributions Set : Begin N = 19 I% = (1.05/1.07)-1 = PMT = PV = SOLVE -262, Second step: Find the future value of contributions Set : Begin N = 19 I% = 5 PMT = 0 PV = FV = SOLVE 663, Total EPF savings at the time of retirement: = 240, , = 904, Time Value of Money with Real Rate of Return Real rate of return is the rate of return which is adjusted after considering the factor of inflation. Inflation, as we understand, has a negative impact on the time value of money. Therefore, it should be considered in the calculation of time value of money. Its basic formula: R = 1+r g 40

51 Whereby: R = Real rate of return r = Profit rate g = Growth rate Therefore, if the expected rate of return is 5% and the inflation rate is 4%, the real rate of return is % Real Rate of Return = = % This real rate of return is to be used for all calculations involving rate of return that needs to be adjusted to the factor of inflation. For example, in calculating the required expenses for life after retirement, the factor of inflation must be considered to coordinate the rate of return in order to obtain the total pension fund that needs to be available at the age of 55. Example: Mrs. Rokiah, 40 years old, would like to maintain her current lifestyle after retiring. The total monthly expenses of Mrs. Rokiah and her family is RM4,000. Therefore, Mrs. Rokiah would like a post-retirement income of RM48,000 per year. Based on a 4% inflation rate, the income required when Mrs. Rokiah is at the age of 55 is: Set : End N = I% = 4.00 PV = FV = SOLVE86, per year 41

52 The amount of RM86, is the future value for the income required by Mrs. Rokiah when she is at the age of 55, after considering the factor of inflation. This amount will continue to increase based on the inflation rate. Therefore, to obtain an amount which Mrs. Rokiah needs to accumulate in order to accommodate her life for 20 years after retirement, Mrs. Rokiah needs to find a present value for an amount which can produce income that increases in line with inflation. Assuming Mrs. Rokiah places the amount or fund in an investment instrument which provides a 5% return, the real rate of return for Mrs. Rokiah s pension fund is %, after considering the factor of inflation. Hence, the present value of Mrs. Rokiah s pension fund is: Set : Begin N = 20 I% = PMT = PV = SOLVE RM1,727, This means that in order to acquire a post-retirement income which increases at a 4% rate for 20 years, the amount that Mrs. Rokiah needs to have at the age of 55 is RM1,727, Conclusion Time value of money is an important concept in investment. It is used to determine the investment value which should be done today in order to earn an amount of money in the future or to calculate the total revenue of future investment after being involved in today s investment. The time value of money concept is also the basis of determining the total profit for financing products in financial institutions. It is also the basis for calculation in order to determine the instalment payments by borrowers. Therefore, it is a necessity in the knowledge of investment. 42

53 CHAPTER 4 PORTFOLIO THEORY AND ASSET VALUATION MODEL Learning Objectives: At the end of this chapter, you are able to: 1. Explain the diversification concept and portfolio 2. Apply the diversification concept in Modern Portfolio Theory 3. Understand the concept of efficient portfolio and efficient frontier 4.1 Introduction to the Diversification Concept and Portfolio Diversification is the act of diversifying investment assets for the purpose of minimising risks and maximising returns. Diversification means expanding investments to several branches, i.e. to not place money in one investment instrument only; instead to enter several investment instruments. It is similar to not putting all eggs in one basket, because if the basket drops, odds are all eggs will be broken. Similarly, if we invest all our money in the stocks of one company, if the stock value plummets, we may lose the money we invested. A diversified investment portfolio has several classes of investments, for example equities, fixed income instruments and derivatives. Each class of investment in turn may comprise several types of different assets. For example in a class of equities, the portfolio can be diversified by holding the shares of listed companies, unit trusts, real estate investment trusts and exchange-traded funds. The next step is to diversify the investment within an asset type. For instance, if buying shares from listed companies, buy from varying sectors, and within the sector, buy the shares of several diverse companies. Or if buying unit trusts, buy more than one type (i.e. income funds, growth funds, bond funds, etc.) An example of a diversified portfolio is shown in Table 4.1: 43

54 Table 4.1: Example of Diversification in a Portfolio Class Percentag Asset Type Sector Company e Equity 90% Listed stocks Oil and gas Alam Maritim Berhad Petronas Gas Berhad Plantation IOI Corporation Berhad KL Kepong Berhad Unit Trusts Growth Fund Public Ittikal CIMB Dana Ihsan Balanced Dana Imbang Islamik Fund Real Estate Services KPJ Al-Aqar REIT Investment Plantation Al-Hadarah REIT Trusts Fixed Income 10% Tabung Haji - - Savings A good strategy is to combine a high-risk investment with low-risk and to place the investment in each class of investment and asset type. This is necessary so that we have a better chance of succeeding in a specific asset class and within groups of an asset. This is important for a risk and return trade-off. Imagine how it would be if all our savings are tied up in the stock market when we are in a desperate situation and need cash quickly. Of course we will face liquidity problems if at that time the stock market continues to plummet. This situation occurs as a result of not diversifying investments within an asset class. Or we may place all our money in oil and gas shares, and then found out that crude oil prices have plummeted which causes the price of many oil and gas companies to be affected. In this situation, it would be best if we diversify investments within companies that use oil and gas, such as plantation and trade, which of course are enjoying increased profits due to falling oil prices! 44

55 Through diversification, if one of our assets fall badly, other assets we own may experience the opposite impact. The increase in value of the second asset will be able to counter the impact of the first asset. This is the benefit that can be gained from diversification. Overall investment risks can be minimised whereas the average rate of return can be maximised. However, avoid from excessive diversification of investment assets. Investing in too many financial instruments is also unwise as it is difficult to monitor all investments at the same time. Excessive diversification of investments may also cause counterbalance between one asset and another which may cause a decrease in rate of return. 4.2 Diversification and Modern Portfolio Theory Modern Portfolio Theory (MPT) is a theory which explains how an investment portfolio can gain full benefit from diversification. This theory is introduced by Harry Martkowitz in According to this theory, diversification will give optimum results when the combined assets are not perfectly correlated. Not perfectly correlated is a situation where two or more assets of investment give a different reaction to an event. For example, the rise in crude palm oil prices give a negative impact to food manufacturers as the costs of raw materials for both of these companies rose. However, it gives a positive effect on the palm oil plantation companies as their sales revenue and profits will increase. Conversely, a perfect correlation means a situation where two or more assets give the same reaction to a change. Referring to the example above, another company which received negative effects due to the rise in crude palm oil prices is soap manufacturers. Hence, shares of food manufacturers and soap manufacturers are perfectly correlated. Hence, in order to gain benefit from diversification, combined assets in a portfolio must not be perfectly correlated. 45

56 According to this theory, investment risks consist of two major types: systematic risk and unsystematic risk. Systematic risks indicate risks which impact all types of investment assets. For example interest rate risk, inflation risk, political risk and currency risk. Conversely, unsystematic risks are risks that impact certain asset classes, sectors or companies only. For instance when Europe banned the import of Malaysian marine products, only companies producing Malaysian marine products feel the impact. This risk is called market risk which only involves specific sectors or industries. Other risks classified as unsystematic risk include management risk, operation risk and product risk. Table 4.2: Systematic Risk and Unsystematic Risk Total risk Diversifiable Risk (Unsystematic) Total risk Investment portfolio Undiversifiable Risk (Systematic) Number of investment assets in portfolio This theory explains that when assets that are not perfectly correlated are combined in one portfolio, unsystematic risk can be fully eliminated. Therefore, the total risk in the portfolio will decline because what remains is only systematic risk. A portfolio which only has systematic risk is called efficient portfolio. 46

57 4.3 Efficient Portfolio and Efficient Frontier Efficient portfolio is a portfolio which provides the highest return at a certain level of risk or the lowest risk at a certain level of return. The lines which link these efficient portfolios are called Efficient Frontiers. Efficient Frontier represents a set of portfolios which provide the highest return at a certain level of risk or the lowest risk at a certain level of return. Not a single point on the line of this Efficient Frontier is better than other points. In other words, not a single combination of assets which are on the line of the Efficient Frontier is better than other combination of assets on that line. Therefore, investors need to measure their respective level of risk tolerance in order to identify the portfolio which has a suitable risk and return profile. In theory, as long as the selected portfolio is on the line of the Efficient Frontier, it will provide the highest return at a certain level or the lowest risk at a certain level of return. The concept of efficient frontier is shown in Diagram 4.3. Notice that the optimal portfolio is the portfolio which is on the line of Efficient Frontier. The portfolio which is positioned above the Efficient Frontier is impossible to achieve as it is not possible for investors to gain a higher rate of return at a level of risk that is too low. On the other hand, a portfolio which is positioned below the Efficient Frontier is an inefficient portfolio as investors fail to obtain the appropriate return at the rate of risk faced by the portfolio. 47

58 Diagram 4.3: Efficient Frontier Expected Return Efficient Frontier position of efficient portfolios Each point represents portfolio options. Portfolios below the line of Efficient Frontier are inefficient portfolios Risk 4.4 Conclusion Modern Portfolio Theory explains the concept that diversification will only bring benefits in terms of risk reduction when the assets combined are not perfectly correlated. Portfolios which succeed in combining assets that are not perfectly correlated will be able to eliminate unsystematic risks of those assets. When all unsystematic risks are eliminated, what remains in the portfolio are only systematic risks which are indeed unavoidable in investment. This will produce an efficient portfolio, which is a portfolio that provides either the highest return at a certain level of risk, or the lowest risk at a certain rate of return. We should be given the choice to select portfolios that are on the Efficient Frontier. This is because all portfolios on the Efficient Frontier are efficient portfolios. Therefore, it is important for us to understand the risk and return characteristics of an asset and the asset correlation with other assets in order to ensure the portfolio we build will truly provide the expected risk and return. 48

59 CHAPTER 5 PORTFOLIO MANAGEMENT AND ASSET MANAGEMENT STRATEGIES Learning Objectives: At the end of this chapter, you are able to: 1. Types of investment strategies practiced by investors 2. Method of evaluating the financial performance of an investment 3. Strategies to rebalance all investment portfolios 5.1 Investment Strategies Investment strategies consist of basic investment strategy, investment strategy in growth market and investment strategy in volatile market. The investment strategy of an individual depends on several factors: Total capital Ability to accept risk Knowledge on investment Objective of investment Basic Investment Strategy Various forms of investment strategies can be developed based on the expected changes in economy, market and investor s attitude. In general, it can be divided into four: a. Long term strategy b. Short term strategy c. Strategy based on economic sector cycle d. Investment hedging strategy 49

60 a. Long term strategy A long term strategy is a strategy which involves investments that exceed a period of 5 years. It is based on the concept of buy and hold and is usually implemented based on the fundamental approach. This means that investment decisions are made based on fundamental analysis of the past performance and future potential of the company. Investment assets normally comprise luxury company shares as well as government and corporate bonds. The objective of long term strategy focuses on dividend income and long term capital growth. b. Short term strategy Short term investment strategy is a strategy that involves investments within a period of less than a year. Investment decisions are typically made based on technical approach, which is the method of identifying future price movements based on past price performance and trading volume. Technical approach ignores the intrinsic value of investment asset, and instead only focuses on market supply and demand of the investment asset. The investment assets usually consist of speculative stocks which aims to gain profit from the price movements in the short term. c. Strategy based on economic sector cycle A strategy based on changes in the economic cycle is normally carried out by institutional investors who actively manage their investment portfolios. Investment decisions are made based on the analysis of the economic situation. Investments will be made in a viable sector and has the potential to develop based on changes in the economic situation or policy. Monitoring will be done frequently, perhaps quarterly, in order to evaluate the performance of the portfolio. Managers will restructure the portfolio if there are changes in the economy which negatively impact the investment assets in the portfolio. 50

61 d. Investment hedging strategy Investment hedging strategy is a strategy used to ensure the value of portfolio is not affected due to changes in the economy or market. Its purpose is to protect the investment portfolio from various investment risks. Assets that are used for this purpose usually comprise derivatives such as options contracts and futures contracts. Hedging strategy technically means using investment instruments in the market to respond to any price movements in the market. In other words, in order to protect the value, investors need to invest in at least two assets which are negatively correlated assets with opposite price movements. 5.2 Investment Strategies according to Modern Portfolio Theory Discussion pertaining to investment portfolio management cannot stray from the discussion of Modern Portfolio Theory which was developed by Harry Markowitz in This theory can be said to be the most influential in the industry of investment management. According to Markowtiz, the selection of an investment portfolio depends on the situation of the investor. Meanwhile, analysis of investment portfolio, according to Markowitz, need to consider three factors, i.e. returns, risks and correlation in terms of price movements of shares in an investment portfolio (price co-variance of stocks). Markowitz highlighted important investment principles which include: The risks of an investment asset will determine its weightage in the portfolio Diversification, although minor, can significantly reduce portfolio risks The decision to invest in a share needs to be based on the risk-return relationship of the share and other shares in an investment portfolio The higher the returns, the higher the risks Investors, in general, do not like high risks, but desire high returns 51

62 Four analysis on investment portfolios proposed by Markowitz are: Separating efficient portfolios from inefficient portfolios Illustrating a combination of required returns and inherent risks from the investment portfolio Investors or investment managers should be careful in the selection of the required risk-return combination in accordance with the objective of investment Identify investment portfolios which will provide a suitable risk-return combination In conclusion, there are several investment strategies which can be adopted for the purpose of maximising returns and at the same time minimising risks. What is important is that the strategy must be suitable with the respective individual s investment goal and risk profile. 5.3 Conclusion There are various types of investment strategies, beginning from one that is based on the period of investment to one that is based on the economic sector and investment objective. These strategies should be developed in order to fulfil the investment goals of an individual or a group of individuals. The effectiveness of these strategies need to be measured to ensure it remains on the right line. Portfolio revaluation should be carried out to achieve the investment objective. 52

63 CHAPTER 6 COMPANY S FINANCIAL STATEMENT ANALYSIS Learning Objectives: At the end of this chapter, you are able to: 1. What is financial statement and why is it needed? 2. The types of financial statements used in a company s financial report 3. Types of financial analysis and method of calculation 4. What are the limitations of financial statement analysis? 6.1 Introduction to Financial Statement Financial statements are the entries of a financial report which record all financial transactions that occur in an organisation. A financial statement is a comprehensive and structured report which illustrates the financial position and performance of an entity. It can be prepared monthly, quarterly, semi-annually or annually. In general, financial statements need to be prepared at least once a year which is also known as the annual report and usually prepared to encompass an accounting period. These reports are prepared and arranged by the financial analysts, accountants and auditors who ensure that the annual report provides a true account of the financial position of the organisation. Financial statements are important to an organisation because without it we would not know the financial performance of the organisation. In accordance to FRS 101 issued by the Malaysian Accounting Standard Board (MASB), the objective of the financial statement is to provide a true account on the financial position of the organisation including current financial position and financial performance, past performance and future prospects, as well as cash flows of an entity in which these information are useful to various groups of users in making economic decisions. 53

64 Financial statements also show results of monitoring of the management of resources entrusted to an entity. It is for this reason that financial statement reports must adhere to the convention of full disclosure as specified in FRS. FRS 101 has stipulated the minimum information which needs to be reported in the Annual Report of an organisation consist of: (a) statement of financial position (balance sheet) at the end of the period; (b) overall income statement (profit and loss statement) for the period; (c) statement of changes in equity for the period; (d) statement of cash flow for the period; (e) notes to the financial statement which contain the summary of significant accounting policies and explanation of other information. 6.2 Types of Financial Statements The following are several types of financial statements which need to be prepared according to FRS 101: a. Statement of Financial Position Statement of Financial Position, also known as Balance Sheet, is a report which provides information on the financial position of an entity. Balance Sheet provides financial information for a specified time, which is usually at the end of the accounting period such as at 31 December every year if the accounting period of the entity is from 1 January and ends at 31 December. Among the financial information which need to be reported in the Balance Sheet are assets or business property, liabilities or debt incurred by the business and owner s equity or capital invested by owners or shareholders. These information are important to know whether the entity has sufficient capital balance compared to the debts incurred, and to know asset surplus which is after assets are deducted from liabilities whereby these information will greatly help users to make their own decisions. 54

65 b. Income Statement Income statement is a statement which presents the revenues acquired from business activities, expenses involved in order to run business operations and profit or loss from business activities of an entity. This statement is prepared for a specified period, usually for every accounting period such as a year. This income statement provides information regarding the performance and achievement of business activities, whether increasing or decreasing. Apart from that, the management can also monitor and control the expenses so as not to exceed from the acquired income or revenue. c. Statement of Changes in Equity Statement of changes in equity explains the changes in balance of owner s equity from its total at the beginning of the period to the total balance at the end of a specified period. Changes in owner s equity within a period is due to the net profit or loss for the period, the occurrence of increased or decreased business capital and dividend distribution to shareholders. The Statement of Changes in Equity is a statement which links information between Income Statement and Balance Sheet. The changes in balance of owner s equity in the Balance Sheet is shown clearly in this statement. d. Statement of Cash Flow Statement of cash flow is a statement that reports the overall net cash inflow and net cash outflow for each business activity which covers operating, investing and financing activities. Information from Statement of Cash Flow are important as it informs the level of liquidity of an entity, the ability to pay dividends to shareholders, shows the relationship between net profit and cash changes in business and able to anticipate future cash flow. 55

66 6.3 Financial Statement Analysis The financial statement of an entity is used by various groups of users to evaluate the financial performance of the entity. This part will focus on basic techniques that are usually applied to analyse information presented in balance sheets and income statements. Information in this financial statement will be more meaningful to users of accounting information if they are able to identify the relationship between the information available in these statements. Two methods typically applied to analyse financial statements are Comparative Analysis and Ratio Analysis. a. Comparative Analysis Comparative analysis is carried out based on 3 bases: a) Intra-company Basis Data in the company itself is compared to similar items but within different years. b) Inter-company Basis Items are compared between one company to another company within the same year in which the companies are subsidiary companies of a parent company or individual companies of the same industry c) Industry Average Basis Comparison is made with the overall averages of performance of companies in the same industry. For example Company A (electrical company) is compared to the industrial figures from various electrical companies. 56

67 There are two types of comparative analysis: vertical analysis and horizontal analysis. Vertical analysis analyses components or items in income statements and balance sheets using relative percentage. This means that each item is compared to one basic item, such as net sales in income statement and total net assets in balance sheet. Vertical analysis illustrates the relative increase of an item compared to the total of specific items in the statement as well as informs significant changes which may occur to items reported in the statement. Vertical analysis is useful to enable users to compare between companies of varying sizes in order to evaluate the financial performance and position of the company. Horizontal analysis (trend analysis), on the other hand, compares data of financial report by using a specified year as the basis year for comparison. For example, the percentage of return on sales in years 2010 and 2011 are compared to the percentage in year 2009 which is used as the basis year for comparison. b. Ratio Analysis Ratio analysis is a method of analysis that compares the ringgit amount of a specific item reported in the financial statement with another item related to the financial statement. Ratio analysis is used to show the relationship between one quantity with another quantity. The relationship is shown in the form of percentage, proportion or ratio. Ratio analysis can be divided into: i. Liquidity Ratio ii. Efficiency Ratio iii. Profitability Ratio iv. Solvency Ratio 57

68 The following illustration will be used in every example to show the calculation of each ratio. Maju Berhad Income Statement for year ended 31 December 2010 (RM) 2009 (RM) Sales (net) 1,185,000 1,159,500 Less : Sales Cost (741,000) (684,000) Gross Profit 444, ,500 Operating expense 330, ,500 Interest expense 22,500 32,500 Total expense 352, ,000 Income before tax 91,500 81,500 Income tax expense (25%) 22,875 20,375 Net Income 68,625 61,125 58

69 Maju Berhad Balance Sheet as at 31 December 2010 (RM) 2009 (RM) Current Assets Cash 30,000 27,000 Marketable Security 31,500 37,500 Accounts Receivable (Net) 118, ,000 Inventories 315, ,500 Past Expense 6,000 7,500 Total Current Assets 501, ,500 Fixed Assets Plant and Equipment 240, ,500 Total Assets 741, ,000 Current Liabilities Accounts Payable 99, ,500 Notes Payable 20,000 45,000 Total Current Liabilities 119, ,500 Long term Liabilities Bonds Payable 210, ,000 Total Liabilities 329, ,500 Shareholders Equity Preference Shares 60,000 60,000 Common Stock, par value of RM1.50 per share 195, ,000 Additional paid-up capital 65,000 39,000 Retained earnings 91,125 40,500 Total Shareholders Equity 411, ,500 Total Liabilities and Equity 741, ,000 59

70 Additional information: Maju Berhadhas declared and paid cash dividends on preference shares amounting to RM2,400 in year 2010 and RM2,200 in year Holders of common stock receive cash dividends of RM15,600 in year 2010 and RM9,750 in year On 31 December 2009, the market price of common stock is RM1.80 per share and on 31 December 2010 is RM2.00 per share. i. Liquidity Ratio Liquidity ratio measures the short term ability of a company to pay their debts or obligations which are due and to fulfil unexpected cash needs. The ability of the company to pay current debts is the main factor to evaluate the short term financial strength of a company. Five types of ratios applied in the analysis of liquidity ratio are: Quick Ratio Quick ratio shows the relationship between cash, marketable security and net receivable with current liabilities. This ratio measures the company s ability to pay its short term debts quickly or immediately. The higher the ratio, the more liquid the company s financial position is. Formula: Quick Ratio = Current Liability Cash + Marketable Security + Net Receivable 60

71 Example: Quick ratio for Maju Berhad is calculated as follows: Quick ratio (2010) = RM30, , ,500 = 1.03 : 1 RM119,875 Quick ratio (2009) = RM27, , ,000 = 1.24 : 1 RM154,500 Current Ratio Current ratio which is also known as working capital ratio shows the relationship between current assets and current liabilities on a specific date. It is used to evaluate the company s liquidity and company s ability to pay short term debts. A high current ratio shows the company s ability to pay its short term debts within a period of less than 12 months. Formula : Current Ratio = Current Assets Current Liabilities Example: Current ratio for Maju Berhad is calculated as follows: Current ratio (2010) = RM501,000 RM119,875 = 4.18 : 1 61

72 Current ratio (2009) = RM487,500 RM154,500 = 3.16 : 1 ii. Efficiency Ratio Efficiency ratio measures the level of effectiveness in the management of the company s assets. The company s efficiency in managing assets will indirectly influence the level of profit. The efficiency level is measured in the management of fixed assets, current assets, inventories, accounts receivable, etc. Inventory Turnover This ratio measures the average number of times inventory is sold within a specific period (usually 12 months which is one accounting period). Inventory turnover ratio is applied to show the sufficiency of inventory and efficiency of its management. If the total inventory in store is small, but the number of sales is high, this indicates that management is considered good. Formula: Inventory Turnover = Sales Cost AverageInventory Balance Example: Inventory turnover for Maju Berhad is calculated as follows: Inventory Turnover = RM741,000 (2010) (RM304, ,000)/2 = 2.39 times Inventory Turnover = RM684,000 (2009) (RM295,000* + 304,500)/2 = 2.28 times * assuming that beginning inventory balance of 2009 is RM295,000 62

73 Accounts Receivable Turnover This ratio measures the average number of times the balance of receivable can be collected in any one period. This ratio shows the company s efficiency in credit extension and debt collection activities. The higher the accounts receivable turnover, the more efficient the company is in managing its debtors. Formula: Accounts Receivable = Net Sales Turnover Average Account Balance of Net Receivable Example: Accounts Receivable Turnover for Maju Berhad is calculated as follows: Accounts Receivable = RM1,185,000 Turnover (2010) (RM111, ,500)/2 = times Accounts Receivable = RM1,159,500 Turnover (2009) (RM95,000* + 111,000)/2 = times * assuming that the 2009 beginning balance of Accounts receivable is RM95,000 and all sales are on credit Average Collection Period Average collection period shows the average number of days to collect accounts receivable. The purpose is to evaluate the effectiveness of the credit policies and collection policies practiced by the company. The company s collection policies are considered effective if the average number of days required to collect must be nearly the same length as the time permitted by the terms of sales of the company. 63

74 Formula: Average Collection Period = 365 days Accounts receivable turnover Example: Average Collection Period for Maju Berhad is calculated as follows: Average Collection = 365 days Period (2010) = 35.4 days Average Collection = 365 days Period (2009) = 32.4 days iii. Profitability Ratio Profitability ratio is used to measure revenue of the operational capacity of a business for a specific period. The company s profitability impacts its ability to acquire loans, ability to issue stocks and ability to grow. Several financial ratios that are usually applied to evaluate the company s profitability include profit margin, return on assets, return on shareholders equity, earnings per share, price earnings ratio, and payout ratio (dividend yield). Profit Margin Profit margin which is also known as return on sales shows the total net income obtained from each sale within a period. Formula: Profit Margin = Net Income 100% Net Sales 64

75 Example: Profit margin for Maju Berhad is calculated as follows: Profit margin (2010) = RM68,625 x 100% RM1,185,000 = 5.79% Profit margin (2009) = RM61,125 x 100% RM1,159,500 = 5.27% Return on Assets Return on assets measures the company s overall profitability. It shows whether the company s assets are used effectively to gain profit. It is stated in the form of percentage whereby the higher the percentage, the more efficient and productive the company is. Formula : Return on Assets = Net Income 100% Average Assets Example: Return on assets for Maju Berhad is calculated as follows: Return on assets (2010) = RM68, % (RM699, ,000)/2 = 9.53% Return on assets (2009) = RM61, % (RM650,000* + 699,000)/2 = 9.06% * assuming the 2009 beginning balance of assets is RM650,000 65

76 Return on Shareholder s Equity Return on shareholder s equity measures the rate of return earned by common stockholders on their investment. The higher the percentage is the better as it indicates a better business and is capable of producing a high profit to common stockholders. Formula : Return on Shareholder s = Net Income Dividend SK 100% Equity Average Shareholder s Equity Example: Return on shareholders equity for Maju Berhad is calculated as follows: Return on Shareholder s = (RM68,625 2,400) 100% Equity (2010) (RM334, ,125)/2 = 17.76% Return on Shareholder s = (RM61,125 2,200) 100% Equity (2009) (RM315,000* + 334,500)/2 = 18.14% *assuming the 2009 beginning balance of Shareholders Equity is RM315,000 Earnings Per Share Earnings per share measures the net profit for common stockholders after deduction of dividend to holders of preference shares. It is expressed in Ringgit Malaysia. Formula : Earnings Per Share = Net Income Dividend SK Average Number of Common Stock Issued 66

77 Example: Earnings per share for Maju Berhad is calculated as follows: Earnings Per Share (2010) = (RM68,625 2,400 (130, ,000)/2 = RM0.51 per share Earnings Per Share (2009) = (RM61,125 2,200 (130, ,000)/2 = RM0.45 per share Price Earnings Ratio Price earnings ratio measures the market price of each common stock compared with the earnings per share of the company. This ratio indicates investors evaluation towards the earnings of the company in the future. Formula: Price Earnings Ratio = Market Price of Common Stock Earnings Per Share Example: Price earnings ratio of Maju Berhad is calculated as follows: Price Earnings Ratio (2010) = RM2.00 / RM0.51 = 3.92 : 1 Price Earnings Ratio (2009) = RM1.80 / RM0.45 = 4 : 1 Payout Ratio (Dividend Yield) Payout ratio measures the percentage of the company s earnings which is distributed in the form of cash dividends. A company which has a high growth rate will record a low payout rate as a considerable part of the company s net income will be reinvested. 67

78 Formula : Payout ratio = Cash Dividend 100% Net Income Example: Payout ratio of Maju Berhad can be calculated as follows: Payout ratio (2010) = RM15,600 / RM68, % = 22.73% Payout ratio (2009) = RM9,750 / RM61, % = 15.95% iv. Solvency Ratio Solvency ratio measures the ability and capacity of a business to continue operating in the long run. Long term creditors and common stockholders usually would like to know the level of ability of the company to pay all its long term financial obligations. The ratios pertaining to solvency are: Debt to Total Assets Ratio Debt to total assets ratio is applied to measure the percentage of total assets acquired through creditor s financing. Formula: Debt to Total Assets Ratio = Total Liabilities 100% Total Assets Example: Debt to total assets ratio for Maju Berhad is calculated as follows: Debt to Total Assets Ratio (2010) = RM329, % RM741,000 = 44.52% 68

79 Debt to Total Assets Ratio (2009) = RM364, % RM699,000 = 52.15% Times Interest Earned (Interest Coverage Ratio) Times interest earned measures the company s ability to fulfil interest payment requirements when financing such as loans reach maturity. The higher the times interest earned, the stronger the company s position is and it shows that the company is capable in paying the interest expense to creditors. Formula: Times Interest Earned = Income Before Tax and Interest Expense Interest Expense Example: Times Interest Earned for Maju Berhad is calculated as follows: Times interest earned (2010) = (RM91, ,500) RM22,500 = 5.07 times Times interest earned (2009) = (RM81, ,500) RM32,500 = 3.51 times Debt to Equity Ratio Debt to equity ratio measures the percentage of total equity that is financed by debt. The lower the debt to equity ratio, the higher the ability of the company to pay the shareholders. 69

80 Formula: Debt to Equity Ratio = Total Liabilities 100% Total Equity Example: Debt to equity ratio for Maju Berhad is calculated as follows: Debt to equity ratio (2010) = RM329,875 / RM411, % = 80.24% Debt to equity ratio (2009) = RM364,500 / RM334, % = % 6.4 Limitations of Financial Analysis Although financial statement analysis provides many benefits to stakeholders, either external or internal, this analysis also has many limitations or weaknesses. Among them are: a) When comparing between one company with another, of course each company has differences in terms of accounting policies which they practice in preparing the financial statement. For example in the evaluation of inventory, there are companies which apply the First-in First-out method, and there are those which apply the First-in Last-out method. Hence comparison for ending inventory cannot be carried out accurately. b) Information in financial statements that are used as the basis of calculation are stated at a historical cost and not at current value. This means that the decisions that will be made for future actions are based on past performance. c) Financial statements contain a lot of information which are obtained through estimates such as provision for doubtful debts and depreciation. This causes the calculation to become inaccurate. 70

81 d) Financial analysis which are calculated may be able to show that a financial problem exists but does not show how this problem occurred. e) Ratio calculated based on a financial statement that is prepared for a specified year has limited use. To gain a clearer view, it is important to consider the trend for several accounting periods. f) Accounting ratios calculated based on data at the end of the year only indicate the position at the end of that year and do not consider the position or operation throughout the year. It does not provide a complete account on the company s financial position throughout the period. g) The calculations of accounting ratios are easily manipulated to show a better financial performance or position. 6.5 Conclusion Financial statement analysis is very important and is the basis of evaluating a company. The ability to analyse financial statements will enable investors to make accurate investment decisions. It will allow investors to evaluate the company s financial performance in terms of its ability to pay off current and long term debts, operating efficiency, ability to produce profit and investor evaluation on the company s shares in the market. It also helps investors to evaluate the price which they should pay on the shares in order to ensure they gain optimum returns from the investment. 71

82 Learning Objectives: At the end of this chapter, you are able to: CHAPTER 7 STOCK EVALUATION 1. Explain the definition of stock and strength and weakness of stock investment 2. Explain the concept of stock valuation 3. Estimate stock price through dividend growth 4. Calculate the rate of return on stock 5. Understand relative valuation of stocks 7.1 Introduction to Stocks and Stock Investment A stock is a piece of paper that enables its holder to claim the right to an asset based on the amount he invested. By owning the shares of a company, investors will have the right to attend the Annual General Meeting and vote on a resolution of the company. Investors are also entitled to the company s profit which are usually distributed in the form of dividends and bonuses. Investors may also receive capital gains if the stock price increases in the future. However, there are several risks in stock investment. The risks are: 1. Stock price may decline due to incurred loss of the company s business 2. The shares may be delisted if the loss is too severe and protracted 3. Stocks may not be able to be traded if there is no demand or supply 7.2 StockValuation Like bonds, the value of shares depends on the present value of money flow generated by these shares in the future. Two items are required: Required rate of return on the shares Estimated future cash flow 72

83 The rate of return should be determined by: 1. Real rate of return without risk 2. Expected inflation rate 3. Risk premium, depends on the risk of the asset. The higher the risk of an asset, the higher the risk premium. Example one period You would like to buy the shares of ABC company and expect that a dividend of RM2.00 will be paid in the first year, and you can sell it at the price of RM14 at the end of the year. If you require a rate of return of 20% for this share, what is the price you are willing to pay today? Calculate the present value of cash flow, which is dividend and price changes Price = PV = (14 + 2) / (1.2) = RM13.33 Calculator: FV = 16; I/Y = 20; N = 1; CPT PV = Example two periods If you would like to hold it for two years, you will receive a dividend of RM2.10 in the second year and its selling price becomes RM What is the share price now? Price = PV = 2 / (1.2) + ( ) / (1.2) 2 = Example three periods If you hold it for three years, you will receive a dividend of RM2.205 in the third year and its selling price becomes RM What is the price now? Price = PV = 2 / / (1.2) 2 + ( ) / (1.2) 3 =

84 We can continue for a few more years, but the lesson is that the current price of a stock is the total present value of cash flow of the stock. 7.3 Estimating a Stock Price It is impossible for us to accurately and positively predict future dividends. Hence we take a simple approach by examining 3 forms of dividend flows: 1. Fixed dividend (g=0, g=dividend growth rate) Dividends are paid in the same amount on an ongoing basis. This is a perpetuity flow, hence its valuation is the perpetuity model 2. Fixed dividend growth (g>0, g is fixed) Dividends will increase at the same rate from year to year 3. Extraordinary growth (g is variable) Dividends initially vary from year to year, and after several years will grow at a fixed rate Zero growth Zero growth means that the amount of dividend is fixed year after year. As common stock has no age limit, the dividends flow continuously. This flow is called perpetuity. The present value of perpetuity is: P 0 = D / R 74

85 If a share is expected to pay a fixed dividend of RM0.50 semi-annually. If the required return is 10% per year, what is the fair price for the share now, if the dividend is compounded semi-annually? Price = P 0 =.50 / (.1 / 2) = RM Fixed growth Dividends grow at a fixed rate every year. P 0 = D 1 /(1+R) + D 2 /(1+R) 2 + D 3 /(1+R) 3 + P 0 = D 0 (1+g)/(1+R) + D 0 (1+g) 2 /(1+R) 2 + D 0 (1+g) 3 /(1+R) 3 + Whereby P 0 = current price, D=dividend, g=dividend growth rate, R=required return With a few algebraic steps on a series of numbers, we will get the following brief formula: D0(1 g) R - g D R - g 1 P0 Example 1 Let s say PQR Company has just paid a dividend of RM0.50 (this is D 0 ),and it is expected that dividends will increase each year at the rate of 2%. If the market requires a rate of return of 15% on the stock, what is the fair price? D0(1 g) R - g D R - g 1 P0 P 0 =.50(1+.02) / ( ) = RM

86 Example 2 TBP Company is expected to pay a dividend of RM2 in the first year. If the dividend is expected to increase at the rate of 5% per year, and the required rate of return is 20%, what is the price now? P 0 = 2 / ( ) = RM13.33 Note: RM2 is D1 = D0(1+g). Here D0 is not given and not required. Example 3 GGC Company is expected to pay a dividend of RM4 next year, and is expected to grow at a rate of 6% per year. The required return is 16%. What is the price now? P 0 = 4 / ( ) = $40 What is the price at the end of year 4? P 4 = D 4 (1 + g) / (R g) = D 5 / (R g) P 4 = 4(1+.06) 4 / ( ) = Non-fixed growth PQR Company is expected to increase dividend at a rate of 20% in the first year and 15% in the second year, after which the dividend will grow at a fixed rate of 5% each year continuously. If the final dividend paid is RM1 and the required return is 20%, what is the fair price now? 76

87 Reminder: We need to calculate the cash flows for years 1 and 2. In year 2, we receive D2 and selling price P2. Non-fixed growth 3-step solution 1. Calculate dividend to the level of constant growth D 1 = 1(1.2) = RM1.20 D 2 = 1.20(1.15) = RM1.38 D 3 = 1.38(1.05) = RM Calculate forward price using constant growth formula P 2 = D 3 / (R g) = / ( ) = Calculate present value of cash flow P 0 = 1.20 / (1.2) + ( ) / (1.2) 2 = 8.67 Activity: 1. What is the fair price of stock that is expected to pay a fixed dividend of RM2 per year if the required rate of return is 15%? 2. What is the price if the company starts to increase the dividend at a rate of 3% per year beginning next year, and the required rate remains unchanged at 15%? 7.4 Calculating Rate of Return Original formula P 0 D make R the formulasubject : D R 0 0 (1 g) R - g (1 g) D g P P 0 D1 R - g 1 0 g 77

88 Calculating rate of return Example: The stocks of DEFcompany are sold at a price of RM The company has just paid a dividend of RM1 and the dividend is expected to increase by 5% per year. Calculate the required rate of return. R = [1(1.05)/10.50] +.05 = 15% What is the dividend yield? 1(1.05) / = 10% What is the capital gain? g =5% Note: Overall return = dividend yield + capital gain. Activity: The current price of XYZ stocks is RM50. The expected future dividend is RM2 and will increase at a rate of 6% per year. 1. Calculate the expected return on this stock. 2. If the required rate of return for this stock is 12%, what is the fair price of the stock? And what is the dividend yield? 78

89 7.5 Relative Valuation This is actually not a valuation model there is no price theory for it it is more to determine the best time to buy or sell stocks. It is suitable for use in: comparison over a period of time, comparison with other assets within the same industry There are several relative valuation models which are frequently used by stock analysts, and two of the popular ones are: Price-earnings ratio (PER) Market-to-book ratio Price-earnings ratio (PER) PER is calculated by dividingcurrent market price with earnings per share. Current PER is used to estimate future price based on the expected profit that the company may earn. If profits are forecasted to rise, in theory prices will also rice. Based on this principle, the stock is considered valuable for purchase as it will provide profits to investors. The PER of a company is compared to the PER of the industry. If the PER of a company is lower than the PER of the industry, this shows that the stock is still cheap and should be purchased as it has the potential to rise. Studies prove that stocks with a low PER provides more profit in comparison to stocks with a high PER. Therefore, smart investors are always on the lookout for stocks with a low PER for the purpose of investment. 79

90 7.6 Conclusion Stock valuation enables investors to determine the appropriate price to be paid by investors for the stocks of a company. It is valuated based on the financial performance of the company, specifically from the aspect of earnings per share (EPS) and also the willingness of investors to pay for the stock price which is measured using the priceearnings ratio (PER). 80

91 CHAPTER 8 BOND VALUATION Learning Objectives: At the end of this chapter, you are able to: 1. Understand the definition of bond and its characteristics 2. Explain the method of valuating bond and the results 3. Calculate the yield to maturity (YTM) rate 4. Understand bond rating activities 5. Understand the various types of bonds Introduction to Bonds When an organisation, either government or corporate companies, would like to borrow money in order to finance their major projects or operations in the long run, they usually issue debt securities which are commonly known as bonds. Bonds are interest-based instruments in which bond issuers or money borrowers will pay interest to investors or lenders in every term which is normally six months. The principal total will only be paid back at the end of the loan period. For example, Yasmeen Berhad would like to obtain a fund of RM100 million to finance a highway project. It aims to issue 100 units of bonds worth RM1 million each for a period of 30 years. The agreed interest rate is 12%. Therefore, Yasmeen is required to pay 12% x RM1 million = RM120 thousand in the form of interest to each bond holder for 30 years. At the end of year 30, Yasmeen will pay all of the principal total of RM1million to each of the bond holders. 81

92 Based on the example above, several terms pertaining to bonds must be learned. Total interest paid throughout the bond period is called coupon. The 12% interest rate is called coupon rate. The principal total which will be obtained at the end of the 30-year period is called face value, or par value, while the bond holding period is called maturity period. 8.2 Bond Value and Results Interest rates frequently change, but cash flows from bonds do not change. This causes the bond value to fluctuate in line with the changes in interest rates. When interest rates rise, the current value for bond cash flows will fall, causing the bond value to also fall. Conversely, when interest rates fall, the bond value will rise. To determine the bond value for a specific period, we need to know the remaining length of period until the bond matures. We also need to know the face value, coupon and interest rate for bonds of similar characteristics. The interest rate required for bonds of the same characteristics is known as yield to maturity (YTM). This rate is sometimes simply referred to as yield. By obtaining all of the information above, we will be able to determine the current value of cash flow as a measure to current market value of bonds. Example: Zain Berhad issued a bond with a maturity period of 10 years and annual coupon of RM80. A similar bond in the market provides a yield to maturity of 8%. The face value of Zain s bond is RM1,000. The cash flows for the bond is shown in Table 8.2. Table 8.2: Bond Cash Flows of Zain Berhad Year Coupon (RM) Face Value (RM) 1, ,080 82

93 As shown in Table 8.2, Zain s bond has the components of annuity (coupon) and single amount (face value paid at the end of the maturity period). We can determine the current value of bonds by calculating the current value (present value) for both of these components separately then adding them. First: Present value for face value (principal) which will be paid at the end of the maturity period: PV = FV/(1+r) n = 1,000/(1.08) 10 = Second: Present value for coupon PV = A x (1-1/(1+r) n )/r = 80 x (1-1/2.1589)/0.08 = 80 x = Hence, the present value for Zain s bond is RM RM = RM1,000 Notice that this bond is sold at face value. This is not a coincidence. The factor which causes the bond price to equal its face value is because the interest rate in the bond market is 8%, similar to the bond coupon rateitself (RM80/RM1,000 = 8%). To see how the bond value changes when interest rate changes, let s assume after a year, the market interest rate increases to 10%. Hence, to calculate the bond value, repeat the method above. Take note that Zain s bond at the time has 9 more years to mature. 83

94 First: Present value for face value (principal) which will be paid at the end of the maturity period: PV = FV/(1+r) n = 1,000/(1.10) 9 = 1,000/ = Second: Present value for coupon PV = A x (1-1/(1+r) n )/r = 80 x (1-1/2.3579)/0.10 = 80 x = Therefore, the present value for Zain s bond is RM RM = RM In other words, it shows that at a coupon rate of 8%, the bond needs to be traded at the price of RM to produce 10%. Why is this bond traded at a cheaper price than its face value? This is because, since the bond gives a coupon rate which is lower than the market, investors are only willing to pay a lower price for the bond. Such bonds are called discountbonds. This happens as investors want a return that is worth the amount they invested. Hence, to ensure the money they invested provides a yield which is similar to the market, they pay lower in order to obtain built-in gain. For Zain s bond, the difference in price is RM1,000 RM884 = RM115. Therefore, investors who buy Zain s bond and hold it until maturity will earn RM80 per year and a profit of RM115 at maturity. This profit provides compensation for bond holders with a coupon rate lower than in the market. 84

95 Another way to see why the bond is traded at a discount of RM115 is by looking at the discount rate on its coupon. Bond holders of Zain Berhad will only obtain RM80 for 9 years while new bond holders receive RM100. Hence the present value of RM20 for 9 years is: PV = A x (1-1/(1+r) n )/r = 20 x (1-1/2.3579)/0.10 = 20 x = It is clear that the present value for the reduced RM20 is the same as the discount price of the bond. What if interest rates fall by 2%, which is 6%? As mentioned earlier in this chapter, bond prices will increase if interest rates fall. Bonds that are sold at a higher price than the face value is called premium bonds. First: Present value for face value (principal) which will be paid at the end of the maturity period: PV = FV/(1+r) n = 1,000/(1.06) 9 = 1,000/ = Second: Present value for coupon PV = A x (1-1/(1+r) n )/r = 80 x (1-1/1.6895)/0.06 = 80 x =

96 Hence, present value for Zain s bond is RM RM544.14= RM1, The bond price is RM above face value. Again, we can justify the excess (premium) by calculating the present value for the difference of the coupon received and the market coupon. The coupon received is RM80 whereas the coupon at the market rate is RM60. The premium of RM20 for 9 years gives a present value of: PV = A x (1-1/(1+r) n )/r = 20 x (1-1/1.6895)/0.06 = 20 x = Based on the example above, if the bond has (1) a face value of F which will be paid at the end of the maturity period, (2) a coupon payment of C for a period, (3) a period of t until maturity, and (4) yield of r for a period, hence the bond value is: (1 r) Bond price C r t F (1 r) t Present value of coupon+ Present value of principal (face value) 86

97 Table 8.2: Relationship between Bond Price and Yield to Maturity (YTM) Bond Price Yield to Maturity Relationship of Price, Coupon Rate and Yield (YTM) If YTM = coupon rate, price = par value IfYTM>coupon rate, price <par value IfYTM<coupon rate, price >par value 8.3 Yield to Maturity (YTM) Yield to maturity (YTM) is the hidden rate of return which equates current price of bond with present value for coupon and par. YTM without a financial calculator is done through trial and error, specifically by taking several specific rates and calculating the PV until obtaining a rate which gives the same PV as the bond price. With a financial calculator, finding the YTM is easy. 87

98 Calculating YTM Example 1: A bond of 10% coupon rate paid annually has 15 years of maturity period and par value of RM1,000. Current price is RM Calculate the YTM. Is the YTM less or more than the coupon rate? N = 15; PV = ; FV = 1,000; PMT = 100 CPT I/Y = 11% Example 2: If a bond of 10% coupon rate paid semi-annually, with face value of RM1,000 and maturity period of 20 years is sold with the price of RM1,187.93, what is the YTM? Is the YTM less or more than 10%? What is the amount of interest every semi-annually? How many times are the interest payments? N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT I/Y = 4% (this is the semiannual rate) YTM = 4%*2 = 8% Activity: Calculate the current price of bond with par of RM1,000 and coupon rate of 6% paid semi-annually and has 9 years before maturity. If YTM is 5%. Is this a discount or premium bond? If YTM is 7%. Is this a discount or premium bond? 88

99 8.4 Bond Rating Who evaluates bond risks? It is done by bond rating agencies, such as RAM Ratings SdnBhd and Malaysia Rating Corporation Berhad in Malaysia, Moody s and S&P in USA. Bonds with the highest quality receives a grade of AAA, followed by AA, A, BBB, BB, and so on for those with higher risks. Bond risks (and rating) depend on the strength of the assurance available in the bond contract in paying the coupon rate and redeeming the bond at the end of the maturity period. Bonds from the same company may not receive the same rating, as it depends on the assurance of each bond. In general the grades of bonds have the following meanings: Grade A and above is deemed the best grade (or investment grade) and the lowest risk Grade B is medium risk (investment grade) Grade C is high risk and high rate (speculative bond) Bond rating agencies have their own notations for bond grading. ForStandard & Poor's, the grades used are: AAA and AA: investment grade, high credit quality AA and BBB: investment grade, medium credit quality BB, B, CCC, CC, C: speculative grade, low credit quality, also called junk bonds 89

100 8.5 Government Bonds Government bonds are called: Treasury bills are short-term bonds (a year or less), with no interest (zero coupon rate), and sold at discount prices. Treasury notes are medium-term bonds, 1-10 years, with coupon rate and par value. Treasury bonds are long-term bonds, exceeding 10 years, with coupon rate and par value. Tax exempt interest Municipal bonds Issued by municipal councils Possess risks similar to bonds of private companies Tax exempt interest 8.6 Conclusion Bonds are significant instruments for a company to acquire funding for its operations. For investors, it is an investment instrument with a fixed income. The skill to evaluate a bond is very important especially for those who work as investment analysts, investment traders or portfolio managers. This is because bonds are vital assets to balance the risks in a portfolio. For individual investors, investment in bonds are only made indirectly through unit trusts. Therefore, it is sufficient if individual investors to understand the concept of bond, the rate of return which can be expected and the risks involved in bond investment. 90

101 CHAPTER 9 INVESTMENT PERFORMANCE EVALUATION Learning Objectives: At the end of this chapter, you are able to: 1. Understand the concept of portfolio evaluation 2. Understand the criteria for portfolio evaluation 3. Measure portfolio performance according to Sharp, Treynor and Jensen 4. Rebalance investment portfolio 5. Identify the trade-off in the decision to rebalance a portfolio 9.1 Introduction to the Concept of Investment Performance Evaluation Changes occur almost every day which causes the environment to no longer be similar to the time when we drafted the investment portfolio that is line with the financial goal of the customer. Perhaps when we started the retirement plan portfolio of the customer in 2009, the world s political situation was considered to be quite stable. We may have suggested investment in MENA (Middle East and North Africa) equity fund which focused on equity investment in Middle East and North Africa in order to gain benefit from the growth of the oil and gas industry which is indeed prosperous in the region. Unfortunately, the political unrest in MENA is now very distressing. This requires investment portfolios to be measured and perhaps revised to take into account the risks that initially did not exist in the investment environment. Investment Analysts and Portfolio Managers are responsible for monitoring and evaluating the performance of portfolios that they manage on a regular basis. The ability of Portfolio Managers to match the performance of the market is dependent on their skills and experience. Among the characteristics of a good Portfolio Manager are: Skill to select investment assets which are suitable with the investment goal and risk profile of the fund 91

102 Their capability to anticipate movements in the market by accurately estimating the rate of return and risks Ability to diversify investment assets in order to maximise returns and at the same time minimise risks Wisdom to reduce investment-related risks and apply Beta estimation in selecting assets to reduce systematic risks Efficiency in determining the appropriatetime to enter and exit the market Skill to analyse investments in order to identify high-value assets with low prices The two main factors influencing portfolio performance are the returns obtained and the rate of risks faced by the portfolio. Managers need to diversify investment assets by selecting assets from various industries, classes and instruments in order to minimise risks at a specific level of returns. Market-related risks should be managed wisely by choosing assets with an appropriate Beta. 9.2 Criteria for Portfolio Evaluation Portfolio Managers, regardless of whether they are Professional Fund Managers or investors who manage their own funds, must continuously monitor their portfolio and revise their portfolio if the need arises. Portfolio evaluation, which is followed by revision and perhaps reconstruction are necessary steps in portfolio management in order to ensure financial goals of individuals are achieved. Managers and investors need to evaluate their performance in organising and implementing investment strategies. This can be done by conducting an absolute or comparative measurement on the rate of return for a unit of risk. Absolute means observing the performance of individual assets, whereas comparative means comparing the returns of the asset with other assets, or with the overall market. They need to evaluate the extent to which the investment objectives are achieved, i.e. in terms of income, capital growth, risk-return trade-off, and so on. 92

103 In this context, the evaluation should consider whether the portfolio achieves a rate of return which is more than, equal to or less than the market average. The ability to diversify assets to reduce or perhaps eliminate the overall unsystematic risks, and the skill to manage market-related systematic risks using the risk measurement method, namely Beta, as well as the wisdom to select appropriate investment assets, are primary factors in determining the performance of a portfolio. Other than that, the skill to apply market timing techniques also play a role in determining market performance. This technique is concerned with determining the appropriate time to enter and exit the market. The diversification method pioneered by Markowitz or Sharpe s Single Index Model will reduce market-related risks and maximise returns at a certain level of risk. Since market returns correlate positively with risks, the evaluation should consider: 1) Rate of return, or excess returns in comparison to risk-free rate of return 2) Degree of risks, namely systematic risks (Beta) and unsystematic risks, and residual risks that remain after portfolio is diversified Under the Traditional theory, evaluation is only done from the aspect of rate of return, especially by comparing the asset with other assets of similar risk class. Markowitz s theory and Modern Portfolio Theory have paved the way for the selection and evaluation of a portfolio based on Risk Adjusted Return. Modern Portfolio Theory suggests that the selection and evaluation of risks are made by considering both risk and return and the goal must be to optimise returns at a certain level of risk or minimise risks at a specific level of return. Due to the volatility of returns and diverse high levels of risks, Risk Adjusted Return has become the basis for evaluation. This development occurred after the creation of the risk measurement method called standard deviation, variance and covariance. Under the Traditional Theory, there is no composite index which measures both risk and return together. Conversely under the Modern Portfolio Theory, it is necessary to build a composite index to measure both risk and return as the objective now is to maximise return and minimise risk. Due to the risk-return trade-off principle which proves that the higher the expected return, 93

104 the greater the risk that need to be taken in order to obtain it, the goal of Modern Portfolio Theory may not be achieved. In this context, recent studies attempt to create a composite index to measure rate of return based on risk by considering various risk components such as systematic and unsystematic, and residual risks after the portfolio is diversified. This effort was successfully done by Sharpe, Treynor and Jensen The Sharpe Measure Method The Sharpe measure method applies the following formula: ST = R t R f δ t Whereby ST is Sharpe Index when R t is the average return of the portfolio and R f is the risk-free rate of return. This method measures total risk using standard deviation. The numerator of this formula compares the average rate of return of a portfolio with the risk-free rate of return. This is known as Risk Premium, which means excess returns that is obtained by taking risks. The total risk is the denominator of this formula which is represented by the standard deviation of returns. By applying the formula above, we are able to measure excess returns for each unit of portfolio risk which was successfully attained as a result of the skills of the portfolio manager. The method used by Sharpe enables all portfolios to be compared based on ST measurement, which is the excess return for one unit of risk. If one portfolio has a higher ST compared to the others, this means that the portfolio has a better performance. 94

105 Let s look at the following example: Portfolio Average Return Standard Deviation Rf (Risk-free Rate of Return) A 20% 4% 10% B 24% 8% 10% Based on the Sharpe formula, ST for Portfolio A ST A = = 0.10 = 2.50% ST for Portfolio B ST B = = 0.14 = 1.75% As Portfolio A shows a higher ST which is 2.5% compared to Portfolio B which has an ST of 1.75%, Portfolio A is said to record a better performance. Diagram 13.4 explains this statement. 95

106 Diagram13.4: The Sharpe Performance Measure Y ST = 2.5 ST = 1.75 Expected Rate of Return Risk-free Rate of Return X Deviation The Treynor Performance Measure Method According to the Treynor method, total risk should consider portfolio risk compared to market risk. Therefore, the denominator in the Treynor formula applies Beta, which is portfolio risk compared to market, and not standard deviation as applied by Sharpe who only considers the portfolio risk. This means that Treynor considers systematic risks in the market which cannot be eliminated. The formula used by Treyor is as follows: 96

107 T n = R n R f β t Whereby: β n T n = Treynor evaluation measure R n = Rate of Return of Portfolio R f = Market risk = Risk-free Rate of Return Treynor founded the formula based on Characteristic Line. Characteristic Line is a simple regression which shows the relationship between excess returns on a portfolio by considering returns for risk-free portfolio whereby Beta coefficient as the slope for risk measure cannot be diversified. This concept can be graphically explained in Diagram The regression line is formed by the following equation: Rp = α + βx + e Whereby; Rp = Returns of the portfolio α= Intercept displaying risk-free returns β= Slope of line x = Market return e = Error term 97

108 Diagram 13.5: The Treynor Performance Measure Y Rate of Return of Portfolio Rp = α + βx + e α Risk-free Rate of Return β (Angle for regression line) X Market Returns 2 Example: Portfolio Average Return β Rf (Risk-free Rate of Return) A 20% % B 24% % T n for Portfolio A T na = = 0.10 = 0.2% T n for Portfolio B T nb = = 0.14 = 0.14%

109 Therefore, the conclusion is that Portfolio A has a better performance compared to Portfolio B as T na is greater than T nb. The difference between the Sharpe and Treynor measure methods are as follows: Sharpe measures portfolio performance based on the total risk, namely systematic and unsystematic, whereas Treynor only considers systematic risk as relevant to the portfolio performance. Unsystematic risks are risks which are concerned with specific investment assets such as management risk, demand risk and technology risk. These risks can be eliminated by diversification. For instance, demand for palm oil can be affected as a result of negative campaigns by soybean producers in the USA. Therefore, as investors in Malaysia, to reduce exposure of our portfolio to palm oil demand, we can diversify our portfolio by investing in oil, cocoa or perhaps rubber based products. This action can reduce unsystematic risks of palm oil demand onthe portfolio. Systematic risks, on the other hand, are market-related risks which involve all investment assets regardless of the types of investments, asset classes, industries or companies. Examples of systematic risks are interest rate risk, foreign exchange rate risk, inflation risk, political risk and environmental risk. These risks usually cannot be eliminated and must be borne by investors. For example, the increase in interest rates negatively impacts most companies. Rising capital costs cause profit margin to fall which leads to the decline of stock market performance. Political unrest or war also has a negative effect on nearly all industries in the Countries involved. Simply look at the economy which is almost crippled in countries in the Middle East and North Africa now. Natural disasters such as the earthquake and tsunami which hit Japan earlier this year are also examples of systematic risks. It had to be borne by investors as its impact extends to all industries in Japan and gives the domino effect on trading partners of Japan in the world. This is called systematic risk. 99

110 Returning to the difference between the Sharpe and Treynor measure methods, Sharpe considers total risk while Treynor only focuses on systematic risk. The higher the systematic risk taken, the greater the potential return on the portfolio. Therefore, if unsystematic risks are successfully managed, then what remains in the Sharpe formula is only market risk the higher the risk, the higher the return. Hence, this causes the measure of portfolio performance using both Sharpe and Treynor methods to provide similar results in terms of portfolio position The Jensen Performance Measure Method The Jensen performance measure method is quite different from Sharpe and Treynor. This is because both Sharpe and Treynor methods measure portfolio performance and position the portfolio performance based on risk adjusted return while Jensen measures absolute performance of portfolio based on risk adjusted return. The standard which is based on the concept of Capital Asset Pricing Model measures the forecasting ability of Portfolio Managers to achieve a higher return at a specific level of risk. The Jensen Model R Jt - R ft = α J + β J (R Mt - R ft ) Whereby; R Jt = Average Return of Portfolio J for period 't' R ft = Risk-free Rate of Return for period t' α J β J = Intercept on graph, measuring the forecasting ability of portfolio managers = Systematic Risk Measure R Mt = Average Return of Market Portfolio for period t 100

111 When α J = 0, performance is neutral or equal to the market α J > 0, performance is better than the market α J < 0, performance is worse than the market The Jensen approach can be understood by looking at the following illustration: Portfolio Portfolio Returns β Portfolio 1 18% % % 1.5 Market Index 16% 1.0 Given that the market Beta is 1.0 and risk-free rate of return is 10%. Hence, the performance of the portfolios can be measured using the CAPM approach as follows: R Jt - R ft = α J + β J (R Mt - R ft ) Portfolio (1) = 10% + (16% - 10%)1.2 = 17.2% Portfolio (2) = 10% + (16% - 10%)0.8 = 14.8% Portfolio (3) = 10% + (16% - 10%)1.5 = 19.0% 101

112 Hence, the actual performance as compared to estimation: Portfolio (1) = 18% % = 0.8% Portfolio (2) = 15% % = 0.2% Portfolio (3) = 21% % = 2.0% The above data shows that the best portfolio management, based on the Jensen method, is Portfolio 3, which has a better performance than the market and provides a return of 2% above the CAPM rate of return at the market risk level. However, all three portfolios show a better performance than the market with returns above the rate obtained by CAPM. Criteria for Portfolio Evaluation The Index Model by Treynor and Sharpe measures performance of several portfolio and positions these portfolios based on their performance record of the highest risk adjusted returns in comparison. Conversely Jensen measures absolute performance based on risk adjusted returns which are compared to the real returns of the respective portfolios. A simple version of Jensen can be seen through the brief model below: R Jt - R ft = α J + β J (R Mt - R ft ) Whereby; R Jt = Average Return of Portfolio J for period 't' R ft = Risk-free Rate of Return for period t' α J β J = Intercept on graph, measuring forecasting ability of portfolio manager = Systematic Risk Measure R Mt = Average Return of Market Portfolio for period t 102

113 The Jensen measure method is shown graphically in Diagram For Sharpe and Treynor, the intercept will go through the coordinate (0,0), but for Jensen, it can go through any coordinate including (0,0). Y Diagram 13.6: The Jensen Measure α J > 0 R Mt - R ft α J = 0 α J <0 0 β J (R Mt - R ft ) X If α is positive, it shows a better performance than the market, α negative indicates a poor performance, while α = odisplays a neutral performance, which is parallel to the market. In comparison to the Sharpe and Treynor methods which compare portfolio performance with other portfolios and the market, the Jensen method is more focused on the absolute performance of the portfolio, specifically observing the actual performance of the portfolio as compared to the performance of the portfolio under CAPM. 103

114 9.3 Rebalancing Investment Portfolios The act to rebalance a portfolio is a risk control strategy which is very effective. In the long run, assets in the portfolio will produce returns of various rates. This will cause the portfolio to deviate from the original position of asset allocation. This change will lead to changes in the risk and return profile of the portfolio which may make it inconsistent with the customer s goal and risk profile.the strategy to rebalance the portfolio helps in controlling this risk by providing a line of action on how the rebalancing process should be carried out. It includes: How frequent is the monitoring that should be done How far is the deviation of asset allocation from its original position before the action of rebalancing is taken Whether rebalancing process on a regular basis is able to return the portfolio to the original asset allocation or to an intermediate allocation. Although in principle a general line of action can be applied to all rebalancing strategies, a specific line of action that is appropriate for a particular portfolio is unique for that portfolio only. As each line of action has an effect on the risk and return profile of the portfolio; frequency, range of deviation and ability to return to the original position depends on the preference of the investor. Factors which influence the decision to implement a portfolio rebalancing strategy are: Net return investors will rebalance a portfolio if the risk taken is equal to the net return after considering the cost of rebalancing the portfolio. Characteristics of the assets in the portfolio if the assets in the portfolio has low correlation among them, the risk of the portfolio to deviate from its original position is quite low. This makes the need to rebalance a portfolio also low. 104

115 9.4 Trade-off in the Decision to Rebalance Similar to choosing an asset allocation strategy that is appropriate for the portfolio, the strategy to rebalance involves trade-off between risk and return. In asset allocation, risk and return is absolute. For example, to earn an expected return of 10%, it involves risk volatility of 15%, while to gain an expected return of 5%, the risk may be 7%. Conversely, in the strategy to rebalance a portfolio, risk and return are measured relative to the performance of the target asset allocation. Decisions which influence the effectiveness of portfolio rebalancing strategy include: Frequency of portfolio monitoring Range of deviation as compared to the original position which prompted the rebalancing action Whether the portfolio is rebalanced to the original position or to an intermediate allocation. If a portfolio has never been rebalanced, in the long run it will deviate from the original position of asset allocation to assets with a profile of high return and high risk. Example: Portfolio ABC of RM1 million in size is invested in equities and bonds with an asset allocation of 60% equities and 40% bonds. At the end of the year, equities provide a return of 20%, whereas bonds only 5%. This causes the asset allocation to deviate from its original position of 60:40 to a new position of 63:37. See the table below for a clearer illustration. Asset class Initial asset allocation Return Final asset allocation Equities RM600,000 60% 20% RM720, % Bonds RM400,000 40% 5% RM420, % Total RM1,000, % RM1,140, % 105

116 In comparison to the original position of the asset allocation, when returns increase, the position of the asset allocation will change. This trade-off is known as Rebalancing Frontier as shown in Diagram 9.7. Diagram9.7: Rebalancing Trade-off as compared to Target Asset Allocation Y Expected Return Deviation Investor Preference: Lowrisk returns Before costs: Trade-off Frontier After costs: Trade-off Frontier 0 Risk of Return Deviation X Target allocation: Expected return deviation = 0 Risk of return deviation = 0 106

117 When portfolio exposure to equity increases, the portfolio will move to the top-right part of the rebalancing frontier. This is a position with the potential to provide high returns, in which the risks are also high. 9.5 Conclusion Investment performance evaluation is a significant skill to ensure investors achieve their investment goals. The ability to evaluate the performance of an investment will help investors to take appropriate actions to improve the performance, if it is found that the results are not as expected. Investors can also rebalance a portfolio if the risk profile of the portfolio has deviated from the original position. All of these actions need to be done in order to achieve the original objective of investment, which is to gain optimum return at a level of risk that can be accepted by investors. 107

118 REFERENCES: Avadhani, V.A.. Securlties Analysis and Portfolio Management, Global Media, Mumbai, India, 2009 KamarulzamanBakri, Analisis, Proses Dan Strategi Portfolio PelaburanBerteraskanSyariah, Universiti Utara Malaysia, Mei 1999 Reilly & Brown, The Investment Setting, Investment Analysis and Portfolio Management, Thomson South Western, 8 th Edition, 2006 Ross, Westerfield and Jordan, Fundamentals of Corporate Finance, McGraw Hill, 6 th Edition, 2003 YesimTokat, Portfolio Rebalancing in Theory and Practice, Vanguard Investment Counseling& Research towering skills.com 108