Topic

Investment
Returns and
Risks

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Calculate investment returns and risks;
2. Differentiate between expected and realised returns;
3. Explain the concept of portfolio;
4. Calculate portfolio returns and risks;
5. Analyse the concepts of covariance and correlation coefficient and their
effects on portfolio risks; and
6. Describe the concept of efficient frontier.

X INTRODUCTION
This topic focuses on the determination of returns and risks. Before an investor
makes any decisions with regard to his investment plans, he must have some
basic knowledge of the returns and risks of the investment. Apart from helping
the investor to make decisions, returns and risks measures can be used to
compare alternative investments and performance evaluation. This topic will also
show how to determine portfolio returns and risks. Almost all investors will
diversify and invest in more than one asset. In this situation, knowledge of
mathematics of portfolio analysis will be useful.

TOPIC 3 INVESTMENT RETURNS AND RISKS

3.1

W 25

THE CONCEPT OF RETURNS

Investment actually refers to current commitment of present resources,

mainly money, in the hope of gaining future benefits.

The main objective of investment is to increase the wealth of the investor. This
can be achieved by investing in an investment that will provide a return. The
return can then be measured from the cash flow obtained from the investment. If
the investment is in the form of shares, the cash flows obtained are in the form
of dividend and capital gain. Capital gain is the extra selling price above the
purchase price. Investment in bonds, on the other hand, will provide cash flows
in the form of coupon payments and capital gain.
In this topic, share equity will be used for the discussion on the relationship
between cash flows and returns. The following dividend model shows the
relationship between price, dividend and required rate of return.

P0
P0
D1
k

=
=
=

D1
(k  g )

(3.1)

Price or the current value of the share

Expected dividend next year or year 1
Required rate of return (sometimes k is also known as the
expected rate of return)
Rate of growth

An explanation of the above model will be given in Topic 5. The expected

rate of return can be obtained as follows:

D1
g
P0

(3.2)

The above model assumes that investment is done indefinitely. If the investor
invests only for a limited period of time, the calculation of return should be
adjusted accordingly. For example, if the investment is done in two different
periods and the shares are then sold at the end of the period with a price, P1, the
rate of return is:

26 X

TOPIC 3 INVESTMENT RETURNS AND RISKS

D 1 P1  P0

P0
P0

(3.3)

or

(D 1  P1 )  P0

P0

(3.4)

Formula 3.3 above clearly shows how the rate of return is related to the cash
flows received from shares. D1/P0 is known as dividend yield and (P1  P0)/P0 is
the capital gain. If the cash flows are actually realised, then k will be known as
the realised rate of return.
Formula (3.1) is often used for obtaining the share value, P0. It is also used to
show the relationship between the values of P0 with k. The relationship between
P and k is inversely related.
If the investor increases the expected return, the share price will fall. There are
several factors that make the investor require a high rate of return from a share.
One of these factors is due to the increase in the risk of the share.

SELF-CHECK 3.1
In Topics 1 and 2, we were introduced to the concept of investment.
Based on your understanding of the investment concept, why do
people invest? What do they hope to achieve? Explain.

3.2

THE HISTORICAL RATE OF RETURN

Sometimes, for the purpose of measurement and analysis of performance,

we need to determine the investment return from past data or historical data.
However, we have to remember that the past cash flows have been realised, thus
the return determined from such data can also be known as the realised return.
As an example, Table 3.1 shows the price and dividend data from share A for the
past five years.

TOPIC 3 INVESTMENT RETURNS AND RISKS

W 27

Table 3.1: Price, Dividend and Rate of Return

The performance of the share between 1998 and 1999 can be determined
by using formula (3.4).

(0.20  3.50)  3.00

3.00
0.233 or 23.3%

The return for the following years is shown in the Total Return column of Table 3.1.
The returns data above can then be used for further analysis.

3.3

THE AVERAGE RETURN AND STANDARD

DEVIATION

Data from Table 3.1 can be used to determine the average annual return of the
share for the past five years.
The calculation for obtaining the average return is as follows:

Average Return

0.233 0.09 + 0.266 + 0.11

4
0.13 or 13%

This average return shows one descriptive value on the estimated yearly return
that could be achieved from the asset for that five-year period. This return is
assumed to be perpetual and compounded every year. However, as
demonstrated in Table 3.1, the return for each year can be higher or lower than
the average return. In the process of determining the risk, this deviation must be
determined. This process is shown in Table 3.2.
In column three of Table 3.2, there are positive and negative deviation values.
This shows that there exists the actual yearly returns which are higher or lower
than the average return. If we calculate the total in column three, we will see that

28 X

TOPIC 3 INVESTMENT RETURNS AND RISKS

the positive numbers will be reduced by the negative numbers. This will not give
a realistic guidance about the return deviation with the average returns.
Therefore, the deviation values from column three should be squared. This
process is required to get rid of the negative elements of the deviation and the
results are shown in column four.
Table 3.2: Average Return and Standard Deviation
(1)
Period

(2)
Return (R )

0.233

0.09

0.266

0.11

Total

0.519

Average R

0.130

(3)
Deviation"* R - R +

(4)
* R - R +4

0.103

0.011

0.220

0.048

0.136

0.019

0.020

0.000

0
Variance"*V4+
Standard Deviation"*V+

0.078
0.026
0.161

Variance "*V + is the total of column 4 divided by 3. Standard

deviation"*V+ is the square root of the variance.

The variance is calculated by dividing the total in column four by three. This
number 3 is the total number of periods subtracted by 1 (N  1). To get the
Standard Deviation (), the variance has to be square rooted.
In the above example, the average return is 13%. For one standard deviation (1 ),
the return can be above the said average return up to 0.291(0.13 + 0.161) and can
be below the average return up to 0.031 (0.13  0.161). If we look at two times
deviations, the return can be between negative 0.452 and  0.192.
By now, it will be clear that the standard deviation can be used to measure the
range of the probability of returns. The probability of return can be higher or
lower than the average return. This proves that standard deviation is a suitable
measure to describe the risk of a certain asset.
As an example, share A has an average return of 12% and standard deviation of
5%, while share Bs average return is 12% and standard deviation is 2%.
Based on this information we know that share A has a higher risk. Share A in one
deviation can be as high as 17% and can also be as low as 7%. Share B, on the

TOPIC 3 INVESTMENT RETURNS AND RISKS

W 29

other hand, can reach up to 14% and can slide down to 10%. Based on this
standard deviation, share B is less risky.
Generally, the average return R can be determined as follows:
R

Rij

(3.5)

j 3

Standard deviation is determined as below:

ij

*Rij R +4
m 3

(3.5)

Where Rij is return on asset i at time j and total time period is m.

3.4

EXPECTED RETURN

The expected return is the return that is required by the investor.

There are several models that can be used to determine this rate. In this topic, we
will use one short and simple model. Other sophisticated models will be
discussed later in the following topics.
There are three steps involved in determining the expected return.
Step 1: An investor has to recognise several economic situations and estimate
the probability that situations will occur. Economic conditions, for
instance, can be classified as high growth, normal growth, constant,
recession and stagflation. If the investor chooses the share market, the
situations can be divided into bull, constant and bear market.
Step 2: The investor then has to assign probabilities for each situation or
condition.
Step 3: Finally, we have to forecast the required rate of return for each situation.
Table 3.3 shows the example of the above process. There are three market
situations that have been identified. Each of the situations has been given a
probability. Total probability is one. Then, a rate of return will be estimated for
each market condition. The process of determining the probability and estimated

30 X

TOPIC 3 INVESTMENT RETURNS AND RISKS

rate of return can be done with the help of professionals in the economics and
investments fields.
Table 3.3: Expected Return and Standard Deviation
(1)
Market
Situation

(3)
Return Ri

(2)
Probability Pr

(4)

Pr x R i

(5)
Deviation

(6)
(R  ERi)2Pr

Ri  ERi

Bull

0.15

0.3

0.045

0.1425

0.003046

Constant

0.7

0.15

0.105

0.0075

0.000039

Bear

0.15

0.05

0.0075

0.1075

0.001734

Expected
Return ERi

0.1575

Variance (2)

0.004819

Standard
Deviation ()

0.069419

The expected return is obtained by taking the total of the multiplication results of
the rate of return and the probability, i.e., total of column 4. Generally, it can be
shown by the following formula:
m

P R

E *Ri +

j 3

ij

(3.7)

ij

Where, Pij is the probability return of asset i in market situation j and Rij is the
return for asset i in market situation j.
Risk is the deviation of the return from the expected return. It is measured by
determining the variance and the standard deviation. The calculation process is
shown in Table 3.3. Column 5 shows the deviation of the return from the
expected return, while column 6 shows the square of the deviation. The total of
column 6 is known as variance (2). It is important to note that we do not have to
divide this total with any number or value as in equation (3.6). This is a bit
different from the way variance is determined in the previous section. The value
of variance is then square rooted to get the value of standard deviation ().
Generally, the process of determining the variance is as follows:
Vi4

P
j 3

ij

Rij  E *Ri +

(3.8)

and the standard deviation is:

Vi

P ]R
j 3

ij

ij

 E *Ri +_4

(3.9)

TOPIC 3 INVESTMENT RETURNS AND RISKS

W 31

It looks like conceptually there is no difference between the standard deviation

calculation for expected return and the average return. The difference is, in
determining the expected return we have to use the value of probability. The
method of calculating and the use of standard deviation are not much different.
Therefore, standard deviation can still be used to measure investment risk, for
analysing past data and also the expected data.

ACTIVITY 3.1
Select at least three shares listed in the Bursa Malaysia and obtain its
annual report from the companys website. Based on the concept of
return, which share would you invest in? Why?

EXERCISE 3.1
1. What do you understand by risk and return for an investment?
2. Briefly explain the difference(s) between expected rate of return and
average rate of return.
3. What are the components of return if you invest in shares and in
bonds?
4. Ahmad would like to invest in shares of Ingress Corporation. The
current price of the shares is RM2.50. Last year the company paid a
dividend of RM0.20 per share and the dividend is expected to grow
at a rate of 5% per year.
(a)

What is the expected return for Ahmad if he decides to invest

in this company indefinitely?

(b)

What is the expected return if after one year Ahmad sells the
share for RM3?

(c)

What is the dividend yield for this investment?

32 X

TOPIC 3 INVESTMENT RETURNS AND RISKS

3.5

PORTFOLIO

A portfolio is when an investor divides his funds and invests in more than one
asset. The main aim of a portfolio is to reduce risk through diversification.

We will see later that this objective cannot be achieved by simply dividing funds
into different assets. Therefore, the objective of constructing a portfolio is to
determine the amount of funds in each asset that will result in minimum risk
given the level of return that the investor requires.

SELF-CHECK 3.2
If you have RM1 million to invest, would you invest all your money in
one investment? What is the risk of putting all your money in one
investment instead of diversifying investment? Justify your answer.

3.5.1

Portfolio Return

In the previous section, we discussed how the return and risk of a single asset are
determined. Let us say we have a pair of assets as shown in Table 3.4.
Table 3.4: Expected Return and Standard Deviation of Two Assets
Asset

Expected Return

10

18

Standard Deviation

We can either invest in asset A or B or divide our funds between A and B. Lets say the
fund is divided and 50% invested in A and 50% in B. The portfolio return would be:
(0.5 x 10) + (0.5 x 18) = 14
The general formula will look like:

ERP

w AERA  w B ERB

(3.10)

and

w A  wB

(3.11)

TOPIC 3 INVESTMENT RETURNS AND RISKS

W 33

Where ERA and ERB are the expected returns, WA and WB are the weights or
percentage of funds in asset A and B respectively. The total weight of the funds
must be equal to one.
If we have three assets, then the formula becomes:

ERP

w A ERA  w B ERB  wC ERC

(3.12)

and

w A  w B  wC

(3.13)

The general formula if we have n number of assets, the return of the portfolio
and the sum of weights is:

ERP

w AERA  w B ERB  !!! w n ERn .

w A  w B  !!!!! w n

3.5.2

(3.14)

Portfolio Risk

The risk of a portfolio for two assets can be determined using the following
formula:

VP

w A4V A4  w B4V B4  4w Aw BV AB

(3.15)

Where A2 and B2 are the variance of Asset A and Asset B respectively. AB is
known as the covariance of A and B. Lets say the value of this covariance is 43.2.
Based on the example in 3.5.1, 50% of funds is in A, the risk of this portfolio is:

Vp

(0.52 )(6 2 )  (0.52 )(9 2 )  2(0.5)(0.5)(43.2) 7.13

(3.16)

This covariance is a new concept that we will discuss next.

3.6

COVARIANCE

Covariance measures the relationship between two assets. The returns of two
shares can move either with each other or against each other.

If the covariance is large and positive, then the two shares returns move in the
same direction. If one of the shares moves up the other share moves up as well. A
small and positive covariance will also mean that the two shares move in the

34 X

TOPIC 3 INVESTMENT RETURNS AND RISKS

same direction. However, the relationship is not strong. There are times when the
shares do not move in the same direction.
A negative covariance means that the two assets will move in the opposite
direction. This means that if one asset moves up, the other will move down. A
large negative covariance will mean the pair of assets will go into different
directions. Table 3.5 shows the technique to calculate covariance.
Table 3.5: Calculation of Covariance and Correlation Coefficients for Pairs of Assets
Cuugv"Tgvwtpu"

Rtqdcdknkv{"
*Pi+

Geqpqoke"Gxgpv"

" Jkij"

20555"

" 37"

"

37"

"

7"

"

32"

"

" Pqtocn"

20555"

" 32"

"

32"

" 32"

"

37"

"

" Nqy"
" Gzrgevgf" Tgvwtp"
" *ERi+

20555"

"

7"

"

7"

" 37"

"

7"

"

" 32"

"

32"

" 32"

"

32"

602:"

" Tkum"*i+

602:"

602:"

602:"

"

"

"

"

"

"

"

" Rcpgn"3<"

"

"

"

"

"

"

Rtqdcdknkv{"
*Pi+

Gxgpv"

*RR"ERR+

*RS"ERS+

*RR"ERR+"*RS"ERS+Pi

" Jkij"

20555"

"

37"

"

7"

" 37" "

7"

" Pqtocn"

20555"

"

32"

"

2"

" 32" "

2"

2022"

" Nqy"

20555"

"

7"

"

/7"

/7"

:055"

"

7" "

:055"

"

"

"

Eqxctkcpeg"*RS+"

"

"

"

Eqttgncvkqp"Eqghhkekgpv"*RS+"

"

"

"

"

"

"

"

" Rcpgn"4<"

"

"

"

"

"

"

Rtqdcdknkv{"
*Pi+

Gxgpv"
" Jkij"

20555"

T
"

37"

*RR"ERR+
"

7"

38089"

V
"

7" "

3"

*RT"ERT+

*RR"ERR+"*RT"ERT+ Pi

/7"

/:055"

" Pqtocn"

20555"

"

32"

"

2"

" 32" "

2"

2022"

" Nqy"

20555"

"

7"

"

/7"

" 37" "

7"

/:055"

"

"

"

Eqxctkcpeg"*RT+"

"

"

"

Eqttgncvkqp"Eqghhkekgpv"*RT+"

"

"

"

"

"

"

"

" Rcpgn"5<"

"

"

"

"

"

"

Rtqdcdknkv{"
*Pi+

Gxgpv"

*RR"ERR+

/38089"
/3"

*RU"ERU+

*RR"ERR+"*RU"ERU+ Pi

" Jkij"

20555"

"

37"

"

7"

" 32" "

2"

2"

" Pqtocn"

20555"

"

32"

"

2"

" 37" "

7"

2"

20555"

"

7"

"

/7"

" Nqy"

"

7" "

/7"

:055"

"

"

"

Eqxctkcpeg"*RU+"

:055"

"

"

"

Eqttgncvkqp"Eqghhkekgpv"*RU+"

207"

"

"

"

"

"

TOPIC 3 INVESTMENT RETURNS AND RISKS

W 35

The top part of Table 3.5 shows the data needed for the calculation. Lets say we
have four assets from R to U and for each asset, we have the probable return for
each event and the probability of the event. This is similar with the concept
discussed in Section 3.4. From the probable returns and the probabilities, the
expected return and standard deviation of each asset can be determined.
For instance, Panel 1 of the table shows the calculation to determine the
covariance of Asset R and Asset S. Column 4 of this section shows that we need
to determine the deviation of each probable return from its expected return. For
example, for asset R, from event 1, the deviation is (15  10).
Column 7, Row 4 of Panel 1 shows the product of two deviations is multiplied
with the probability. In this case, it is the product of two deviations between R
and S. Taking the total value of this column will give the covariance between R
and S.

ACTIVITY 3.2
Select a pair of shares listed in the Bursa Malaysia and determine the
covariance between the shares. You can use the companys annual report
information to obtain relevant information. What can you conclude?

3.6.1

Correlation Coefficient

The value of the covariance can be positive or negative and the value can be any
number. In order to make comparisons between pairs of assets easier and to
standardise the degree of the relationship, we can use the correlation coefficient
(). The  value can be determined by the formula below:

URS

V RS
V RV S

(3.17)

The correlation coefficient between R and S,( RS) is just the covariance of R and
S, (RS) divided by the product of the standard deviation of R(R) and S(S).
The value of  is between 1 and +1. This makes it easier to compare the
relationship between two pairs of assets. Table 3.5, Column 7, Row 5 of Panel 1-3
shows the result of this process.
If a pair of assets has a  of +1, it means that the 2 assets are perfectly positively
correlated. This means that the 2 assets move in a perfect direction. Our example

36 X

TOPIC 3 INVESTMENT RETURNS AND RISKS

showed that for assets R and S, the amount of returns are the same in each event.
Between assets R and T, this relationship is perfectly negative. Observe that the
returns for T are low when the returns for asset U are high. The relationship
between assets R and U however is positive but not perfect.
Table 3.6: The Effect of Correlation Coefficient on a Portfolios Risk
ERA = 32
ERB = 3:

A = 8
B"?";"

"
"

"
"

"
"

"
"

Rcpgn"3<"
wA
3"
20;"
20:"
209"
208"
207"
206"
205"
204"
203"
2"

Eqttgncvkqp"Eqghhkekgpv"*AB"+"?"-3"
4
4
4
4
wB
ERp
w A A
w B B
2"
32"
58"
2"
203"
320:"
4;038"
20:3"
204"
3308"
45026"
5046"
205"
3406"
39086"
904;"
206"
3504"
340;8"
340;8"
207"
36"
;"
42047"
208"
360:"
7098"
4;038"
209"
3708"
5046"
5;08;"
20:"
3806"
3066"
730:6"
20;"
3904"
2058"
87083"
3"
3:"
2"
:3"

4wAwBABAB
2"
;094"
3904:"
4408:"
470;4"
49"
470;4"
4408:"
3904:"
;094"
2"

P
58"
5;08;"
65078"
69083"
730:6"
78047"
820:6"
87083"
92078"
9708;"
:3"

P
8
805
808
80;
904
907
90:
:03
:06
:09
;

Rcpgn"4<"
wA
3"
20;"
20:"
209"
208"
207"
206"
205"
204"
203"
2"

Eqttgncvkqp"Eqghhkekgpv"*AB"+"?"/3"
4
4
4
4
wB
ERp
w A A
w B B
2"
32
58"
2"
203"
320:"
4;038"
20:3"
204"
3308"
45026"
5046"
205"
3406"
39086"
904;"
206"
3504"
340;8"
340;8"
207"
36
;"
42047"
208"
360:"
7098"
4;038"
209"
3708"
5046"
5;08;"
20:"
3806"
3066"
730:6"
20;"
3904"
2058"
87083"
3"
3:
2"
:3"

4wAwBABAB
2"
";094"
"3904:"
"4408:"
"470;4"
"49"
"470;4"
"4408:"
"3904:"
";094"
2"

P
58"
42047"
;"
4047"
2"
4047"
;"
42047"
58"
78047"
:3"

P
8
607
5
307
2
307
5
607
8
907
;

Rcpgn"5<"
wA
3"
20;"
20:"
209"
208"
207"
206"
205"
204"
203"
2"

Eqttgncvkqp"Eqghhkekgpv"*AB"+"?"2"
4
4
4
4
wB
ERp
w A A
w B B
2"
32
58"
2"
203"
320:"
4;038"
20:3"
204"
3308"
45026"
5046"
205"
3406"
39086"
904;"
206"
3504"
340;8"
340;8"
207"
36
;"
42047"
208"
360:"
7098"
4;038"
209"
3708"
5046"
5;08;"
20:"
3806"
3066"
730:6"
20;"
3904"
2058"
87083"
3"
3:
2"
:3"

4wAwBABAB
2"
2"
2"
2"
2"
2"
2"
2"
2"
2"
2"

 P
58"
4;0;9"
4804:"
460;5"
470;4"
4;047"
560;4"
640;5"
7504:"
870;9"
:3"

P
8
7069"
7035"
60;;"
702;"
7063"
70;3"
8077"
9052"
:034"
;

TOPIC 3 INVESTMENT RETURNS AND RISKS

W 37

EXERCISE 3.2
The following table shows the historical investment data for an
investor in a company. Answer the following questions based on the
data from the table.
Year

Dividend
(RM)

Purchase Price
(RM)

Selling Price
(RM)

1999

4.00

100.00

97.00

2000

3.50

97.00

97.50

2001

3.40

95.00

94.00

2002

3.60

98.00

109.00

2003

3.60

99.50

112.00

(a)

What is the expected return of the investment in year 2000?

(b)

What is the dividend yield for the investment in 2001 and 2002?

(c)

What is the capital gain for the investment in 2001?

(d)

What is the average return for a five-year investment from 1999

to 2003?

(e)

Calculate the variance and the standard deviation for the fiveyear investment?

3.6.2

Correlation Coefficient and Portfolio Risk

When the correlation coefficient is used, the formula to determine a portfolios

risk is as follows:
VP

w A4 V A4  w B4V B4  4w Aw B U ABV AV B

(3.18)

The correlation coefficient value can affect the risk of the Portfolio. Let us say we
have the two assets A and B from the previous example as shown in Table 3.7.

38 X

TOPIC 3 INVESTMENT RETURNS AND RISKS

Table 3.7: Expected Return and Standard Deviation of Two Assets

Asset
Expected Return
Standard Deviation

A
10
6

B
18
9

If we allocate 50% of the funds in A and 50% in B, the expected return from the
portfolio is:
(0.5 x 10) + (0.5 x 18) = 14
If the correlation coefficient between A and B is +1, the portfolios risk is:
*2074 +*84 +  *2074 +*;4 +  4*207+*207+* 3+*8+*;+

907

When the correlation coefficient is 1, the portfolio risk becomes:

*2074 +*84 +  *2074 +*;4 +  4*207+*207+* 3+*8+*;+

307

The different correlation coefficient has provided two different levels of risk.
Table 3.6 showed the effect of the correlation coefficient on the portfolio risk
when the amount of funds invested in each asset was altered. Panel 1 of Table 3.6
showed the different levels of return and risk with different amounts of funds.
Columns three and eight showed the expected return and risk of the portfolio.
If all the funds are invested in asset A, then all the returns and risk will come
from that asset. If some funds are shifted from A to B, then we notice the
expected returns and risk will change.
Panel 1 of Table 3.6 shows a situation where assets A and B have a correlation
coefficient of +1. Take note that the risk increases when there is a shift of funds
from A to B.

TOPIC 3 INVESTMENT RETURNS AND RISKS

W 39

The different levels of return and their risk is shown in Figure 3.1.

Figure 3.1: Portfolio opportunity set when AB = +1

At point A, the investment is 100% in asset A while at point B it is 100% in asset

B. From point A, the investor shifts funds from A to B and the level of return
increases. The line indicates that the risk increases as the return increases. There
is no risk advantage in shifting funds from A to B, since the increase in the return
is accompanied by an increase in the risk.
Panel 2 of Table 3.6 is a situation when the correlation coefficient is 1. Take note
that the expected returns are the same as in Panel 1. However, the pattern of risk
is very different. We notice that as funds are shifted from A to B, the portfolios
risk decreases. The risk continues to decrease until the level where the fund is
60% in A and 40% in B. At this level, the combination between A and B provide a
return with zero risk. After this level, further shift from A to B will increase
returns, but the level of risk will begin to increase as well.

40 X

TOPIC 3 INVESTMENT RETURNS AND RISKS

The relationship between return and risk when the correlation coefficient is 1 is
shown in Figure 3.2.

Figure 3.2: Portfolio opportunity set when AB = 1

Observe that there are two lines. One line moves from point A to the y-axis. As
before, 100% of the fund is invested at point A. As the investor shifts from A to B,
the return increases but the level of risk decreases. There is an advantage in
shifting funds from A to B. The other line moves from the y-axis to point B. The
returns keep increasing as the funds are shifted. However, this time the risk
increases as well.
Also observe that at some points on the second line the return is more efficient
than the points on the first line. If we refer back to Table 3.6 and look at the
position where 70% of funds are invested in A, the return is 12.4 and the risk
level is 1.5. When 50% of funds are in A, the return is 14 and the risk is also 1.5.
This means that the investor can be more efficient by obtaining a higher return
with the same level of risk.
Combinations of assets in a portfolio that can provide zero risk can only be
obtained if two assets have a correlation coefficient of 1. However, it is very rare
to find two assets moving opposite each other perfectly. This is because assets or

TOPIC 3 INVESTMENT RETURNS AND RISKS

W 41

investments are found within an economy, and the return and risk will be
affected by the general condition of the economy, thus, all of these assets will be
affected by the same variables. Only the degree of relationship is different. At
best, investors can only find pairs of assets that have a correlation coefficient of
less than +1.
Panel 3 in Table 3.6 shows the return and risk if the correlation coefficient
between A and B is 0. Take note that the risk decreases if funds are shifted from
A to B. However, the risk level does not reach zero. All the investor can manage
is to combine the assets and obtain a portfolio with minimum variance. Figure 3.3
shows the relationship between return and risk when the correction coefficient is
0. Observe the portfolio located at the point of minimum variance.

Figure 3.3: Portfolio opportunity set when AB = 0

We can combine Figures 3.1 and 3.2 as shown in Figure 3.4.

42 X

TOPIC 3 INVESTMENT RETURNS AND RISKS

Figure 3.4: Superimposed portfolio opportunity set when AB = +1 and 1

We have noted earlier that the correlation coefficient can only be between +1 and
1. Therefore the lines from these two extremes can be used as a limit that shows
the relationship between returns and risks. If the correlation coefficient is
between +1 and 1, the line or curve must be inside the triangle.
This is illustrated in Figure 3.5. The lines and curves in Figure 3.5 are derived
from the summary in Table 3.6. Also notice that when the correlation coefficient
is 0.8, there is no combination of assets that can provide a minimum risk. This
can be confirmed from the results in Table 3.6 where the correlation coefficient is
0.8, the amount of risk did not decrease when finds are shifted from A to B.

TOPIC 3 INVESTMENT RETURNS AND RISKS

W 43

Figure 3.5: Portfolio opportunity set with different values of AB

Another feature of the curves is that they are convex or curving towards the
y-axis and not away. This feature is in line with the behaviour of an investor who
prefers high returns with low risk. The only situation when the investment
opportunity is a straight line is when the correlation coefficient is +1 or 1.

3.7

ONLY COVARIANCE BETWEEN ASSETS IS

IMPORTANT

Let us look at the formula for portfolio risk when we have three assets, A, B and
C. We will use the formula with covariance as shown below,
VP

w A4 V A4  w B4V B4  wC4 V C4  4w Aw BV AB  4w AwC V AC  4w BwC V BC

(3.19)

44 X

TOPIC 3 INVESTMENT RETURNS AND RISKS

If we have four assets, the formula will look like this,

w A4 V A4  w B4V B4  wC4V C4  w D4 V D4 

VP

4w Aw BV AB  4w AwCV AC  4w Aw DV AD 
4w BwCV BC  4w B w DV BD 

(3.20)

4wC w DV CD

Notice that the number of covariance increases more than the variance. If the
portfolio has two assets, the number of variance is 2 and the number of
covariance is also 2 (AB and BA). If there are three assets, the number of
variance is 3 and the number of covariance is 6 (AB, BA, AC, CA, BC, CB). If
the number of assets is four, the covariance is 12.
As the number of assets in the portfolio increases, the number of covariance will
be greater. The covariance between assets will become the major portion of the
portfolios risk in relation to the individual variance of the assets.
The general situation is that the relationship between the assets in the portfolio
(as measured by the covariance) will be more important than the individual
variance of the asset. As the number of assets gets larger, the investor can ignore
this individual variance of asset. In the next topic, we will see the full effect of
this situation.

3.8

MARKOWITZ EFFICIENT DIVERSIFICATION

Recall that the main objective of constructing a portfolio is to reduce risk through
diversification. In a share market, the investor attempts to distribute risk among a
number of shares. However, this diversification is not simply picking a few
shares at random.
It is pointless to include shares from the same industry as these shares will move
together and the correlation coefficient between them will be high. Markowitz
suggested that shares should be combined by taking into account their
correlation coefficient with each other.
Combinations of shares with correlation less than +1 are most preferable.
Therefore, it is advantageous for the investor if he can mix stocks from different
industries, since some industries do not have perfect correlation. We have seen
the effect of this exercise in the previous section.

TOPIC 3 INVESTMENT RETURNS AND RISKS

3.9

W 45

THE EFFICIENT FRONTIER

An efficient portfolio will always offer the highest return within a risk level. A
portfolio can be more efficient than a single asset since the effect of correlation
coefficient can reduce risk. In other words, the risk of a single asset, when
combined with other assets, can be diversified away. For example, if all the
shares in the market are considered in the construction of portfolios then there
will be some portfolios that are more efficient than others. The minimum
requirement is that there must be at least one share that has a correlation
coefficient of less than +1 with other shares to form an efficient portfolio.
Earlier, we stressed that a portfolio curve moves towards the y-axis. Therefore, if
all shares in the share market are considered and the above condition exists, we
will have a selection of portfolios that are more efficient. These selections of
portfolios will lie on a curve that is known as the efficient frontier. The efficient
frontier is a curve shown in Figure 3.6.

Figure 3.6: The efficient frontier

Only portfolios are on the efficient frontier since individual shares will have
higher risks than portfolios. Individual shares and inefficient portfolios will lie
below the curve.

46 X

TOPIC 3 INVESTMENT RETURNS AND RISKS

ACTIVITY 3.3
Select a pair of shares from two different industries in the Bursa Malaysia.
Jot down their prices at the end of each month for the past 12 months.
Calculate their average return, standard deviation and covariance. Based
on your findings, what can you say about the two industries?

EXERCISE 3.3
1. Abdullah decides to invest in the share market. He gathers some
information about the economic conditions and the probability of
the returns that he will get. You have been assigned to help
Abdullah to determine the risk and return of the investment by
answering the following questions using the data in the given table.
Geqpqoke"
Ukvwcvkqp"

Rtqdcdknkv{""
*Pr+

Tgvwtp"
Eqorcp{"C"

Tgvwtp"
Eqorcp{"D"

Tgeguukqp"

203

32'"

/37'

Cxgtcig"

207

37"

32

Cdqxg"cxgtcig"

205

47"

42

Dqqo"

203

52"

62

(a)

What is the expected return of each asset?

(b)

What is the variance of the return?

(c)

What is the standard deviation of the return?

(d)

What is the range of the return within 1 standard deviation?

(e)

Which company should Abdullah invest in? Why?

2. Use the data from Question 1 and calculate the covariance and
correlation coefficient between the two assets.
3. What is the return and risk of a portfolio that consists of 30% in A
and 70% in B from Question 1?

TOPIC 3 INVESTMENT RETURNS AND RISKS

W 47

4. The following stocks are available for consideration

Uvqemu"

Ri

Vi

47'"

34'"

47"

32"

37"

34"

UNO"?"20:."UNP"?"/20:."UNQ"?"2.""
UOP"?"/3."UOQ"?"20:."UPQ"?"3."

Calculate the return and risk of portfolio that is made up of the

following combinations:
(a)

50% in N and 50% in O

(b)

30% in N, 30% in O and 40% in P

(c)

25% in N, 25% in O, 30% in P and 20% in Q

(d)

Which combination is the best investment in terms of returns

per unit risk?

The main objective of a portfolio is diversification and reducing risk.

To achieve the effect of risk reduction, investors should combine assets that
are less correlated with one another.

Combinations of assets in a portfolio that can provide zero risk can only be
obtained if two assets have a correlated coefficient of 1.

An efficient portfolio is one that offers the most returns for a given amount of
risk, or the least risk for a given amount of returns.