Chapter 3

INVESTING IN STOCKS
 After reading this chapter, students will be

LEARNING able to:

• Identify the most important features of
OUTCOMES ordinary shares and preference shares
• Describe the primary and secondary markets,
and the processes involved in both markets
• Explain margin trading

• Describe the process of short selling

• Identify the factors affecting stock prices

• Explain the concept of risk and return in stock

investment
• Apply the different risk adjusted techniques in
measuring stock portfolio performance
What is a Share of Stock?
A share of stock is a financial security issued by a company to raise long-term capital for business
growth and expansion activities. It is issued in the form of share certificates to its owners in
exchange for their investments in the business.

A share of stock is actually the smallest unit of ownership in a company

If you own a share of a company’s capital, you have become the stockholder or the shareholder of
the company.
Why Invest in Stock?
Dividend income
Dividends are a distribution of profits. If the company declares a cash dividend, each shareholder
receives an equal amount per share. The higher the amount of profits obtained by the company, the
more likely the company will pay a generous dividend per share

Capital gain
Appreciation in value of stock. If the market value of the shares rises, the investor could then
decide whether to sell the shares at the higher price or continue to hold them until they reach a
target price set by the investor. If the investor decides to sell the shares, the difference between the
purchase price and the selling price represents the capital gain or the profits reaped by the investor
Classes of Shares

Two main classes

• Ordinary Shares/Common Stock

• Preference Shares/Preferred Stock

Ordinary Shares
• Ordinary shares are issued to investors who are interested to be the owners of a company.

• A shareholder can be an individual or a company that legally owns one or more shares of stock
in a company.
• Ordinary shares are also known as “equity capital” or “equities” for short.
Privileges of Ordinary Shareholders
The ownership of ordinary shares usually comes with several privileges, legal rights and risk.
These include the following:
1. Voting privileges
2. Right to information
3. Pre-emptive rights
4. Rights to dividends
5. Limited liability
6. The right to sue for wrongful acts
7. Residual claim
 Preference Shares
• Preference shares differ from ordinary shares in that they typically do not carry voting rights but
are legally entitled to receive a certain level of fixed dividend payments before any dividends
could be paid to ordinary shareholders.
• In general, preference shares usually have the following rights attached to them:

1. Before a dividend can be declared on the ordinary shares, any dividend obligation to the
preference shares must first be satisfied.
2. The dividend rights are often cumulative, i.e. if dividend is not paid, it accumulates from year
to year.
3. Preference shares may or may not have a fixed liquidation value, or par value associated with
them. This represents the amount of capital that was contributed to the company when the
shares were first issued.
Preference Shares (continuation)
4. Preference shares have a claim on liquidation proceeds in the event of a company failure. This
claim is equivalent to at least the par value. This claim has higher priority than ordinary shares
which have only a residual claim.
5. Preference shares have a negotiated fixed dividend amount. The dividend is usually specified
as a percentage of the par value of the shares or as a fixed amount.
6. Preference share is often perpetual. Unlike bonds that normally have a defined term from the
start, preference share typically does not, i.e. they can remain outstanding or in circulation
indefinitely. However, most preference shares are callable, which means the issuer can redeem
them at a set price (usually par) before the stated maturity date.
Types of Preference Shares

Cumulative Non-cumulative Participating

preference shares preference shares preference shares

Redeemable Convertible
preference shares preference shares
Categories of Stocks
Stock Category Characteristics
Blue Chip These types of stocks are usually priced high because of their demand. Blue-chip stocks
are shares in large, well-known companies with a solid history of growth. They generally
pay good dividends. They have relatively low volatility and deliver a steady stream of
dividends. They are usually a safe investment that is attractive to conservative investors.
The main downside is that, since they are so large, they have little room to appreciate,
compared to smaller, up- and-coming types of stocks.
Penny Penny stocks are low-priced, speculative stocks that are very risky. These stocks are
generally issued by companies with a short or erratic history of revenues and earnings.
The appeal of penny stocks comes from their low price. Though the odds are against it, if
the company that issued them suddenly finds itself on a growth track, their stock share
price can rise rapidly. This type of stock is popular among small speculators.
Income Income stocks are stocks that pay higher-than-average dividends over a sustained
period. These above-average dividends tend to be paid by large, established companies
with stable earnings. Utilities and telephone company stocks are often classified as
income stock types. Investors buy them for the income they generate.
Categories of Stocks (continuation)
Stock Category Characteristics
Value A value stock is a type of stock that is currently selling at a low price. Companies that
have good earnings and growth potential but whose stock prices do not reflect this are
considered value companies. Value stocks often have a low price-to-earnings (PE) ratio,
i.e. they are cheaper to buy than stocks with a higher PE. Value stocks may be growth or
income stocks, and their low PE ratio may reflect the fact that they have fallen out of
favor with investors for some reason. People buy value stocks in the hope that the market
has overreacted and that the stock’s price will rebound.
Growth Growth stocks have earnings growing at a faster rate than the market average. They
usually do not pay dividends to their shareholders. Investors buy them in the hope of
capital appreciation, i.e. potential rapid growth of the company, hence rapid increase in
share price. A start-up technology company is likely to be a growth stock.
Categories of Stocks (continuation)
Stock Category Characteristics
Defensive Defensive stocks are those whose prices stay stable when the market declines and are issued by
industries that naturally do well during recessions. Food and utilities companies are defensive
stocks. Debt collection companies also tend to perform well when the market turns sour.

Cyclical Cyclical stocks are those that move up or down in sync with the business cycle because the
issuing companies serve the needs of growing economies. Examples include the housing
industry and industrial equipment companies.

Treasury Treasury stock is a type of stock that has been bought back by the company that issued it.
Companies may buy their stock back from investors when they believe it is underpriced on the
market. The companies can then set aside the stock for future uses such as debt payment or
the awarding of stock options.
Market Capitalisation
• Market capitalisation is the total market value of all of a company’s outstanding ordinary shares.

• Market capitalisation reflects the equity value of a company at a certain date. It is the amount of
money that it would require to buy a company outright in a single transaction.
• The market capitalisation and the market value of a company are two different things. However,
the market capitalisation is a part of the market value
• Formula for market capitalisation:

RM500 mill 100 mill RM5 per share

Market Capitalisation Total Number of Ordinary Current Market Price of One

= Shares Issued Out x Share
Market Trends

• The economy is strong • A general decline in the • The market has simply • A market bottom is a
and unemployment is low stock market over a reached the highest point trend reversal, the end of
period of time for some time a market downturn, and
• A decline then follows, precedes the beginning of
usually gradually at first an upward moving trend
and later with more (bull market).
rapidity.

Bull Bear Market Market

Market Market Top Bottom
Primary Market
The primary market, also called the new issue market, is the market for issuing new securities such
as equity shares, preference shares, debentures and bonds.

Known as New Issue Market (NIM).

Many companies that include large privately owned, small and medium-sized companies enter the
primary market to raise money from the public to expand their businesses.

They enter the primary market to earn profit by converting their capital, which is basically a private
capital, into a public one, releasing securities to the public.

They sell their securities to the public through what is known as an Initial Public Offering (IPO).
Why Companies Go Public?
• To obtain more capital to finance growth

• To source long-term capital

• To allow owners to realise their assets

• To make the shares more marketable

• To enable payment of managers by stock options

• To facilitate growth by acquisition

• To enhance the company’s image

• To act as a catalyst for the participation of foreign partners

• To establish good corporate governance practices

• To boost employee pride

Listing Methods
• There are two methods by which an unquoted company can obtain a quotation on the stock
market.
• These two methods are public offering and private placement.

• The first involves offering of the share capital for sale to the public, and the second method
concerns a private offering made to a limited number of parties.
• If a company has already been listed on the stock exchange, it may use rights issue in order to
raise additional capital. The company may offer to existing shareholders, inviting them to
subscribe cash for new shares in proportion to their existing holdings.
Public Offer for Sale
• When companies “go public” for the first time, a “large” issue will probably take
the form of an offer for sale.
• Shares can be offered to the public either at a fixed price or by tender.

• A prospectus will be drawn up and is intended to provide investors with the

information they need to decide whether to invest in the company or otherwise.
Initial Public Offering (IPO)
• An IPO happens when a privately owned company issues shares of stock to be
sold to the general public for the first time.
• The money investors pay for the ordinary shares to become the stockholders of
the company, flows direct to the company that makes the offering.
• IPO is basically a way for a company to raise capital based on expectations of
future success and profit but is highly risky.
• IPO is facilitated by the service of investment banks.
Cost of IPO
• IPOs can vary greatly from one company to another, and they require a long,
expensive and complicated process.
• A company needs to consider not only the costs of engaging underwriters, but
also fees for engaging attorneys, accountants as well as printing costs of
prospectuses and the listing fees imposed by the stock exchange.
Private Placement
• Shares are offered to clients or other contacts of the investment bank
leading the issue, rather than to the general public.
• Costs of advertising the shares and producing documentation are reduced.
This is attractive to smaller companies.
• Disadvantages include shares end up being held by a smaller number of
more powerful investors and that often the discount on the issue is greater
than with public offers.
Rights Issue
• Once a company is listed in the stock exchange (after IPO), it can raise
additional capital through rights issue. The company offer new shares to existing
shareholders (pre-emptive right), inviting them to subscribe cash for new shares
in proportion to their existing holdings.
• A rights issue must be low enough to secure the acceptance of shareholders who
are asked to provide extra funds, but not too low, so as to avoid excessive
dilution of the earnings per share.
Rights Issue (continuation)
As the name implies, the issue gives shareholders the right to buy the additional shares, but it is not
an obligation (it is a form of an option). An existing shareholder therefore has the following options
with a rights issue:
1. Take up his rights by buying the specified proportion at the price offered.
2. Renounce his rights and sell them in the market.
3. Renounce part of his rights and take up the remainder.
4. Do nothing.
 Rights Issue - Example
• Encik Malik holds 2,000 shares of Boustead Berhad. The market
price of the shares currently stands at RM1 per share. The
company announces a “one-for-four” rights issue. The subscription
price for the new shares is fixed at RM0.80 a share.
• Show the changes to En Malik’s wealth if he decides to:
 Take up the rights
 Renounce his rights and sell them in the market
 Renounce part of his rights and take up the remainder.
 Do nothing.
Rights Issue - Take up his rights by buying the specified proportion at the price offered.

• The value of holding before the rights issue:

= 2,000 shares x RM1 = RM2,000.

cum rights price

• En. Malik will have to purchase 500 new shares at a price of RM0.80. Therefore he
has to pay RM400 to the company (500 shares x RM0.80)
• After a few weeks from the initial announcement, the shares go ex-rights (investors
has no longer the rights to buy the new shares). The share price, known as the
“theoretical ex-rights” price will be:
Total value of investment = RM2,000 + RM400 = RM0.96
Total number of shares held 2,000 + 500
No. of share Value per share Total value
Existing - 4 share RM1 4
RI – 1 share RM0.80 0.8
Total = 5 share 4.8
Ex-right price = RM4.80/ 5 shares 0.96
 Rights Issue - Take up his rights

• Current value = RM2,000

• Theoretical value after rights issue (2,500 x RM0.96) = RM2,400

• Less: Purchase price (500 x RM0.80) = RM 400
• Net wealth = RM2,000
• Hence, the overall wealth is unchanged.
Rights Issue - Renounce his rights and sell them in the market
• Since rights have a value, they can be sold on the stock market in the
period between:
The rights being announced and issued to existing shareholders, and
The new issue actually takes place
• Value of a right = RM0.96 – RM0.80 = RM0.16

• By selling 500 rights, he will get 500 x RM0.16 = RM80

• Therefore, change of wealth:

Current value = RM2,000

Theoretical ex-rights price (2,000 x RM0.96) = RM1,920
+ Sale of rights = RM 80
Net wealth = RM2,000
(unchanged)
Rights Issue - Renounce part of his rights and take up the remainder

• En Malik decides to sell 420 of his rights and buys 80 shares.

• By selling 420 rights, he will get 420 x RM0.16 = RM67.

• By buying 80 shares, he has to pay 80 x RM0.80 = RM64

• Therefore, change of wealth:

Current value = RM2,000

Theoretical ex-rights price (2,080 x RM0.96) = RM1,997
Less: Purchase price of 80 shares = RM 64
RM1,933
+ Sale of rights = RM 67
Net wealth = RM2,000
(unchanged)
Rights Issue - Renounce half of his rights and take up the remainder

• No. of rights sold, 250 rights

• Value of rights sold: 250 * 0.16 = RM40

• Exercise, 250 rights to get 250 shares,

Value of investment = 250 *0.80 = RM200

• En. Malik’s wealth

2250 shares * RM0.96 = 2160
Income from rights sold = 40
Cost of investment = (200)
NEW WEALTH = 2000
% owned (2250 * 0.96)/2500 = 86%
 Rights Issue – Do nothing
• Therefore, change of wealth:

Current value = RM2,000

Theoretical ex-rights price (2,000 x RM0.96) = RM1,920
(Net wealth)
Therefore, loss of RM80
Secondary Market
After a stock has been exchanged or sold through the primary market, it can no longer be traded in
the primary market, but the buying and selling of this security can be accomplished in what we call
the secondary market.

The secondary market is a market for existing financial securities that are currently traded among
investors.

Once the stocks are issued and sold in the primary market, they can be sold time and again in the
secondary market.

The fact that stocks can be sold in the secondary market improves the liquidity of stock investments
because the shareholders who are no longer interested in holding their stocks could easily dispose
of these stocks by selling them in the secondary market.
Secondary Market (continuation)
On the other hand, investors who wish to become the new owners of any company could now have
the opportunity to do so by buying the stocks in the secondary market.

This ability to buy and sell stocks in the secondary market is the reason why stocks and other
securities are very popular among investors.

The secondary market is much larger and much more active than the primary market. It is here that
price discovery occurs, and that liquidity is created for investors.

However, transactions in the secondary market do not provide additional funds to the company.
Primary Market vs Secondary Market
 Types of Secondary Market

STOCK EXCHANGE OVER-THE-COUNTER (OTC)

• A stock exchange is a company which provides • Do not have physical locations; instead, trading is
conducted electronically, directly between two parties and
a place and facilities for the trading of financial
without a central exchange or broker.
instruments.
• The OTC market is a network of dealers who buy and sell
• Can be considered as physical marketplace the stocks of companies that are not listed on a stock
where traders and member brokers who exchange.
represent investors meet to buy and sell stocks • Today, the stocks trade on the OTC are not really traded

and other securities on behalf of their clients. over the counter, instead they are traded in an electronic
marketplace via the telephone, facsimile or computer
• Eg; Bursa Malaysia, New York Stock Exchange network.
 Bursa Malaysia
• Bursa Malaysia is the stock exchange of Malaysia. It is based in Kuala Lumpur and
previously known as the Kuala Lumpur Stock Exchange.
• Bursa Malaysia is the only stock exchange approved by the Minister of Finance under the
provisions of the Securities Industry Act 1983.
• Bursa Malaysia is an exchange holding company incorporated in 1976 and listed in 2005.

• It is one of the largest bourses in ASEAN. Bursa Malaysia operates and regulates a fully
integrated exchange offering a comprehensive range of exchange-related facilities including
listing, trading, clearing, settlement and depository services.
• Bursa Malaysia helps over 900 companies raise capital – whether through the Main Market
for established large-cap companies, the ACE Market for emerging companies of all sizes, or
the LEAP Market for up-and-coming SME companies
 Stock Market Indexes
• Stock market indexes track the movements of securities’ prices in a market or a
section of a market.
• Each of the indexes tracks the performance of a specific “basket” of stocks
considered to represent a particular market or sector of the economy.
 FTSE Bursa Malaysia Index Series
• Companies that are listed on the Main Market of Bursa Malaysia are eligible for inclusion in the
following indices:
 FTSE Bursa Malaysia KLCI
 FTSE Bursa Malaysia Mid 70 Index
 FTSE Bursa Malaysia Top 100 Index
 FTSE Bursa Malaysia Small Cap Index
 FTSE Bursa Malaysia EMAS Index
 FTSE Bursa Malaysia MidS Cap Index
 FTSE Bursa Malaysia EMAS Shariah Index
 FTSE Bursa Malaysia Hijrah Shariah Index
 FTSE Bursa Malaysia Small Cap Shariah Index
 FTSE Bursa Malaysia MidS Cap Shariah Index
 FTSE Bursa Malaysia Fledgling Index
 FTSE Bursa Malaysia Palm Oil Plantation Index

• Companies that are listed on the ACE Market of Bursa Malaysia are eligible for inclusion in the
 FTSE Bursa Malaysia ACE Index
 FTSE Bursa Malaysia KLCI
• Used to be known as the Kuala Lumpur Composite Index (KLCI) and is the main stock
market index in Malaysia.

• In July 2009, Bursa Malaysia together with FTSE, its index partner, integrated the KLCI with
internationally accepted index calculation methodology to provide a more investable, tradable
and transparent managed index - FTSE Bursa Malaysia KLCI (FBM KLCI).

• The FTSE Bursa Malaysia KLCI comprises the largest 30 companies (component stocks) listed
on the Main Board by full market capitalisation that meet the eligibility requirements of the
FTSE Bursa Malaysia Index Ground Rules.

• To ensure that the component stocks do not over-present or under-present certain sectors, the
number of component stocks selected for different economic activities is also constantly
correlated with the sectoral contribution to gross domestic product.
Trading Process – Types of Orders
When an investor instructs his broker to buy or to sell, he is actually giving the broker an order.

Placing orders correctly is an important aspect of trading.

On one hand, it will help the investor to achieve a certain profit target for a particular stock
investment.

On the other hand, it may assist the investor to limit the loss that he might suffer in a declining
market.

The following are the types of orders that can be placed by an investor to his broker:
 • It is an order to buy or sell shares immediately.
• This order is usually placed in fast market conditions when the investor wants to ensure that a position is taken and to protect against missing
an opportunity.
Market • The broker will try to get the best price available and the transaction will be completed as soon as possible.
Order

• It is a request to buy or sell shares at a specified price (the limit) or better. A limit order to buy is an order to buy shares at a specific price (the
limit) or at a lower price. It ensures that the investor will buy at the best possible price but not above a specified value set by the investor. A
limit order to buy therefore states the highest price the investor is willing to pay for a purchase
• A limit order to sell, on the other hand, ensures the investor sells at the best possible price, but not below a specified value set by the investor. It
Limit Order is an order placed over the current market price and is the lowest price the investor is willing to accept.

• It is an order to sell a particular stock at the next available opportunity after the price of the stock reaches a specified amount.
• A stop order specifies a price at which an order is to be executed, and therefore can be used to put a limit on loss from an existing position or it
can be used to protect a profit.
• When the stop price is reached, a stop order becomes a market order.
Stop Loss • This type of order is frequently used to protect an investor against a sharp drop in price and therefore reduce the amount of loss on a stock
Order investment.
Trading process
Market order
• To guarantee immediate execution (not to miss any opportunity)
• Does not guarantee price

Limit Order
• To get the best price
• (Sell): order to sell the share when price reach ex: RM15 or above
• (Buy): Order to buy the share when price fall to ex: RM10 or below

Stop order Loss

• To protect investor against further loss
• (Sell): Order to sell if the price of the share fall to ex: RM12 – to prevent further loss
• (Buy): Order to buy if the price of the share increase to ex: RM16 (above market price) – to prevent
further loss
Trading Process – Buying Stock on Margin
Investors who want to buy stock but do not want to pay the price in full can finance their purchase
by buying on margin.

Buying on margin lets investors borrow some of the money needed to buy stocks by setting up a
margin account with a broker.

Usually, the brokerage firm either lends the money or arranges the loan with another financial
institution. Investors who buy on margin will need to pay interest on the borrowings made

An investor is required to deposit a sum of money called the “initial margin” before trading can
commence. It is the amount an investor must pay in cash for securities before the broker will lend
money to that investor. This cash is deposited in the margin account
The initial margin is designed to protect the broker against a fall in the value of securities to the
point they no longer cover the loan.
 Trading Process – Buying Stock on Margin
At the time of opening a margin account, often there is an agreement for a maintenance margin
between the investor and the broker.

The maintenance margin (also known as variation margin) represents a specific minimum amount
of cash balance that the investor must maintain in the margin account on a daily basis in order to
continue trading (open position) in the future until the security is sold.
This margin serves as a reassurance for the broker that the investor would pay back the amount, or
will not default on the expected fluctuation in the price of the security, in case of the trade going
against the investor.
The minimum amount of cash or approved margin collateral that must be maintained in the margin
account again depends on the limit set by the individual brokerage or authority in a particular
country.
Should the balance in the margin account falls below the maintenance margin, the investor will get
a “margin call”, which is a request from the broker to deposit additional fund in the margin account
to meet the maintenance margin requirement before next day trade can commence.
 Buying Stock on Margin (continuation)

• Investors buy on margin because the financial leverage provided by borrowing

money can increase the return on investment.
• To illustrate, let us say Mr. A wants to buy 400 shares of a stock at a current price
of RM20 a share. The total cost would be RM8,000. If he decides to buy on
margin, he will need to deposit RM4,000 (assuming 50% initial margin ratio)
into the margin account and borrow the remaining RM4,000 from the broker.
• In a situation where the share market price of the stock rises to RM40 and he
decides to sell, the proceeds from the sale will be RM16,000. He will then repay
the broker RM4,000 for the amount borrowed and pocket the remaining
RM12,000 himself (minus interest and commissions). The profit made is almost
200% on the RM4,000 original investment.
 Buying Stock on Margin (continuation)
• However, buying on margin can be risky in a declining market. E.g. if the market price of the 400
shares owned by Mr. A drops so much that selling them would not raise enough money to repay the
loan from his broker. Mr. A will then receive a margin call from his broker. This additional margin
is intended to cover the potential fall in the value of the position on the following day.
• For example, it is agreed between the two parties that the broker will issue a margin call if the value
of Mr. A’s investment falls below 75% of his original value.
• Let’s say the value of the shares purchased for RM8,000, has now reduced to RM5,600.This value
is less than RM6,000 [75% the margin requirement (75% x RM8,000)], Mr. A would have to
deposit RM2,400 into the margin account to bring it back to the initial margin amount of RM8,000.
 Example of Margin Trading
DAY VARIATION GAINS BALANCE (RM)
0 Investment Value: 400 shares X RM20 = RM8000
Initial Margins requirements (50%) : RM4000
Amount borrowed from broker: RM4000 4000
1 Share price rise to RM30
Gains: (30 – 20) X 400 = RM4000 8000
2 Share prices drop to RM20
Loss (20 – 30) X 400 = 4000 4000
3 Share prices drop to 15
Loss: (15 -20) X 400 = 2000 2000
Assume maintenance margin: RM3000
Investor will receive a margin call and will have to top up his account by
RM2000 to initial margin 4000
4 Share prices rise to RM45
Gain: (45 – 15 ) X 400 = RM12000 16000

If investors decides to close his account today, his return:

(45 X 400) – 4000-4000 / 4000 + 2000 = 167%
 Selling Short
• Selling short is a way for investors to make money in a declining stock market
by borrowing rather than buying stocks. (refer to next slide for illustration).
• The biggest risk about short selling is how well you can forecast the market
direction. If you correctly predict that a stock will decrease in value, you will
profit from selling short. If you predict incorrectly and the value of the stock
increases, then you will pay more to cover your short position than you made
from selling the stock resulting in a big loss from your investment.
• Gain profit if share price reduce

• Gain loss if share price increase

 Selling Short (continuation)
• To illustrate, assume the current market price of Short Berhad is quoted at RM40 a
share. Due to some economic forecasts, you predict the stock market will decline and
the share price of the company will decrease in value over the next three months. In
order to profit from this situation, you decide to short sell and you contact your
broker to borrow 10,000 shares of Short Berhad. The broker then sells the 10,000
shares on your behalf at the current price of RM40 a share.
• Let us assume that after two months, your prediction is correct, the market is in a
shamble and the share price of the company actually falls to RM20 a share. You then
instruct your broker to buy 10,000 shares of the company at the current RM20 a
share. The 10,000 newly purchased shares are then returned to the broker to replace
the shares that you have borrowed two months ago. From the short selling, you have
actually made RM200,000 (RM400,000 selling price – RM200,000 purchase price =
RM200,000 profit) minus the commissions for buying and selling of the stock to the
broker.
 Earnings
announcement
Analyst
upgrade/ Industry
performance
downgrade

Insider
Dividend
trading
Factors
affecting
Share
Prices
New
Stock
major
splits
contracts

Takeover
Share
and
buy-back
merger
Product
innovation
Stock Return and Risk
Risk can be defined as the uncertainty that actual returns will not match expected returns
A risk-averse investor will only invest his money in risky assets like shares of stock if he expects
that his investment will yield a positive return

The rate of return is defined as the difference between the end of period market price of the asset
and the beginning market price of the asset divided by the beginning market price of the asset

There are two types of risk. The first is called systematic risk, or risk attributed to relatively
uncontrollable external factors. The second is called unsystematic risk, or risk attributed to the
underlying investment

Total risk is equal to the sum of systematic and unsystematic risk

 Types of Risk
S Y S T E M AT I C R I S K U N S Y S T E M AT I C R I S K

• Systematic risk results from conditions, events and • Unlike systematic risk, unsystematic risk is not
trends occurring outside the scope of investment. attributed to external factors.
• At any one point, there are different degrees of • This source of risk is unique to an investment,
each risk occurring. such as how much debt a company possesses,
• These risks will cause the demand for a particular what actions a company’s management takes and
investment to rise or fall, thus impacting actual what industry it operates in.
returns. • 6 principals: business risk, financial risk, industry
• 4 principals: exchange rate risk, interest rate risk, risk, liquidity risk, call risk and regulation risk
market risk and purchasing power risk
Stock Performance Measurements
Measurement of a portfolio’s performance is important to investors.

Many investors mistakenly base the success of their portfolios on returns alone.

Few consider the risk that they have to take to achieve high returns.

Since the 1960s, investors have known how to quantify and measure risk with the variability of
returns, but no single measure actually looked at risk and return together.

Today, there are three risk adjusted techniques that have been developed to measure portfolio
performance.
The Three Stock Performance Measurements
Treynor Index Sharpe Index Jensen Index
• It measures the returns earned by the • This measure closely follows the • Also based on the capital asset pricing
portfolio in excess of that which could capital asset pricing model, and by model.
have been earned on a risk-less extension, uses total risk to compare • This measure is also known as alpha.
investment. portfolios to the capital market line. • Measures how much of the portfolio’s
• This index therefore relates excess • Like the Treynor Index, the Sharpe rate of return is attributable to the
return over the risk-free rate to the Index does not quantify the value manager’s ability to deliver above-
additional risk taken. added, if any, of active portfolio average returns, adjusted for market
• The focus of risk is on systematic risk management. risk.
instead of total risk. • It is a ranking criterion only. • The higher the ratio, the better the risk-
• Therefore, this performance measure • The Sharpe ratio is also used to adjusted returns.
should really only be used by investors characterise how well the return of a • A portfolio with a consistently positive
who hold diversified portfolios. portfolio compensates the investor for excess return will have a positive alpha,
• But the portfolio with a higher total risk the risk taken. while a portfolio with a consistently
is less diversified and therefore has a • The Sharpe ratio is almost similar to negative excess return will have a
higher unsystematic risk which is not the Treynor measure, except that the negative alpha.
priced in the market. risk measure used is the standard
deviation of the portfolio instead of
considering only the systematic risk, as
represented by beta.
Stock Performance Measurements
All the three measures combine risk and return performance into a single value.

This makes it easier to compare the performance of competing portfolios.

Therefore, there is no surprise that all the three indexes are also often used to rank the performance
of portfolio or mutual fund managers.
 Treynor Index

• The higher the Treynor Index, the higher the return

relative to the risk-free rate, per unit of risk.
• The formula is as follows:

Where
Rp = Portfolio return
Rf = Risk free rate of return
βp = Beta of portfolio
 Treynor Index (continuation)

Example
Manager Average Portfolio
Assume that the five-year average annual Annual Beta
return for the KLCI (proxy market Return
portfolio) is 10%, while the average annual A 10% 0.90
return on Malaysian Government
Securities is 5%. You, as the finance B 14% 1.03
director are evaluating three distinct C 15% 1.20
portfolio managers with the following data:
 Treynor Index (continuation)
Computing the Treynor Index (TI) for each manager yields the following
risk-adjusted results:

TI (Market) = (.10 –.05)/1 = .05

TI (Manager A) = (.10 – .05)/0.90 = .056
TI (Manager B) = (.14 – .05)/1.03 = .087
TI (Manager C) = (.15 – .05)/1.20 = .083
If we are to evaluate base on performance alone, we will select Manager C as the best
performer.However, when considering the risks that each manager took to attain their
respective returns, Manager B demonstrated the better outcome. In this case, all three
managers performed better than the aggregate market.
 Sharpe Index
• The Sharpe ratio is almost similar to the Treynor measure, except
that the risk measure used is the standard deviation of the portfolio
instead of considering only the systematic risk, as represented by
beta.
• The higher the portfolio’s mean return relative to the mean risk-
free rate and the lower the standard deviation σp, the higher the
Sharpe Index will be.
• The formula can be expressed as follows:
 Sharpe Index (continuation)
Example
Examine the following example and Manager Average Portfolio
Annual Standard
assuming that the KLCI had a standard Return Deviation
deviation of 18% over a five-year D 14% 11%
period, let us determine the Sharpe
E 17% 20%
ratios for the following portfolio
managers: F 19% 27%
 Sharpe Index (continuation)
The Sharpe Index (SI) computations are as follows:

SI (Market) = (.10 –.05)/.18 = .278

SI (Manager D) = (.14 – .05)/.11 = .818
SI (Manager E) = (.17 – .05)/.20 = .600
SI (Manager F) = (.19 – .05)/.27 = .519
Once again, we find that the best portfolio is not
necessarily the one with the highest return. Instead, it is
the one with the most superior risk-adjusted return, or in
this case the fund headed by manager D.
 Jensen Index
The formula is as follows:

Jensen Index (Alpha) =

Portfolio return – [Risk-free return + (Market return – Risk-free return) * Beta]
 Jensen Index (continuation)
Example
Manager Average Portfolio
Assume a risk-free rate of 5% and a Annual Beta
Return
market return of 10%, what is the alpha
for the following funds? D 11% 0.90

E 15% 1.10

F 15% 1.20
 Jensen Index (continuation)
First, we calculate the portfolio's expected return (ER).
ER (D) = .05 + 0.90 (.10 – .05) = .0950 or 9.5%
ER (E) = .05 + 1.10 (.10 – .05) = .1050 or 10.50%
ER (F) = .05 + 1.20 (.10 – .05) = .1100 or 11%
Then, we calculate the portfolio's alpha by subtracting the expected return of the portfolio
from the actual return:
Alpha D = 11% – 9.5% = 1.5%
Alpha E = 15% – 10.5% = 4.5%
Alpha F = 15% – 11% = 4.0%

Conclusion: Manager E produced the highest alpha and therefore the best performance.
Thank You

ANY QUESTION???