Risk and return measures for investment decisions


CHANCES are most of us have chewed over our risk appetite with a relationship manager at our bank branch. 

Some individuals are risk averse while others thrive on the adrenaline rush that can come from “taking a punt”. Yet, few realise the significance of setting risk and return goals, at the heart of a sensible portfolio.  

Risk drives returns, rather than the other way around. Risk is defined as the frequency and amount that an investment fluctuates from its average return. It is measured using the statistical formula standard deviation, a measure of the variability (dispersion or spread) of any set of numerical values about their arithmetic mean or average. This enables a calculation of the historical volatility of an asset or portfolio.  

The more the investment deviates from that return, the more volatile and risky it is, even if the investment produces higher-than-average returns.  

For example, Sam Ooi purchased stock A at a 10% annual return over 10 years. He enjoyed returns as high as 20% and 0% in other years. Ooi bought stock B at an 8% annual return, with a high of 15% and a low of 5%. Which stock has been less risky? Stock B.  

So, how do we benchmark risk versus return? Firstly, returns must at least equal spending plus inflation. This is known as the real rate of return.  

An investor should decide if he prefers a relative rate of return or an absolute rate of return. The former measures how the investor has performed compared to everyone else or to a proxy for the market such as the KLSE Composite Index (CI). An absolute rate of return refers to the funds earned or lost.  

While many investors believe they are oriented towards a relative rate, most Malaysians aren’t. Almost everyone is relative-oriented in a bull market and absolute-oriented in a bear market.  

James Owen in his book The Prudent Investor explains: “In a bull market, investors want their returns to be close to the top returns while in a bear market, they don’t care how everyone else fared, as long as they didn’t lose money.”  

 

Using key statistics to measure the risk and return of asset classes  

A prudent investor will carefully examine risk and return data when selecting the right asset classes. How does he measure the risk and return of each asset class?  

Money market: The simplest and potentially lowest risk investments after fixed deposit are money market instruments. In Malaysia, individuals can invest in money market through money market unit trusts. These funds invest in short term (one day to 12 months) debt instruments such as Bank Negara bills and commercial paper.  

Although money market funds are less risky funds than equity or bond funds, it still is possible for money market mutual funds to post negative returns, but it is less likely. The biggest risk money market investors face is the risk that inflation will outpace the funds' returns, thereby eroding the purchasing power of the investor's money.  

Bonds: As for bonds, the credit risk, yield and coupon rate measure risk versus returns. Yield is the annual interest rate paid by a bond, expressed as a percentage of its current market price.  

The coupon rate is the fixed rate of interest the bondholder earns at regular intervals until it matures. A more precise measure of a bond’s value is the yield to maturity, or the promised return to an asset if kept to maturity.  

With these elements driving bond prices, a bond unit trust fund managed by fund manager A has varied risks compared with fund manager B. Wise investors should determine such differences from their financial advisors before forming an investment portfolio and regularly review it for changes.  

Rating Agency Malaysia (RAM) conducts companies’ credit rating. An AAA rating refers to an investment-grade bond, with the smallest risk, while an AA bond carries a slightly higher degree of long-term risk. Junk bonds are the lowest-rate corporate bonds (BB and below), with a greater chance that the issuer will fail to repay his debt.  

Today, most new bonds are registered and stored electronically, the way stock purchases are. They are called book-entry bonds. In general, bonds beat inflation, but with substantially lower returns than stocks. People who are risk averse tend to prefer fixed-income securities as opposed to stocks.  

Equity: Price and return on investment (ROI) measure a stock’s worth. ROI simply means that the larger your return, the greater the stock’s value. An investor should look for a company’s track record of strong growth.  

Another risk indicator is ‘beta’, which measures an investment portfolio’s volatility relative to the market, usually the KLSE CI. A beta above 1 is more volatile than the overall market, while a portfolio with beta below 1 is less volatile and more suitable for investors seeking lower risk investment.  

Investors should monitor a stock’s price-earnings ratio (P/E), the market price of a share divided by the earnings per share (EPS) of the company. Generally the higher the P/E ratio, the more expensive a stock is.  

Unit trusts: Unit trusts are popular among institutional and individual investors. Says G. Sivalingam in his book on Investment Management in Malaysia: “Unit trusts can be attractive because it is quite safe for small investors with limited funds to take risks in the stock market.”  

A unit trust manager will try to maximise returns for a given level of risk. The more diversified his portfolio of assets are, the less risky his portfolio will tend to be. An effective unit trust manager will achieve higher returns on his investment than the average returns on the overall market. It is advisable to look for unit trusts and managers that have a strong track record.  

One should also look at the dividend, fees and yield patterns when measuring returns on unit trust funds. Also consider the management and service fee. If a trust charges very high fees, it can make for an expensive investment.  

Ultimately, measuring risk is not an exact science. Ask yourself: do I have to have a positive return each year? If not, can I sustain a 5% or 10% loss?  

You may define risk as the funds you think you could lose and still sleep well at night. This will be fine-tuned as you discuss the virtues of risk-taking with a highly qualified financial consultant.  

 

·The above views reflect those of Citibank Bhd as at the date of publication. They are intended for general information and/or discussion of the topic. They are not intended to be relied on in any way by any investors in foreign currencies or other investment products.  

While every effort has been made to ensure accuracy of the information, no liability whatsoever will be accepted by the bank or the author, whether in contract, tort or otherwise, for any error of fact or omission herein which may lead to any direct or consequential loss arising from any reliance on or use of this report.  

Investors should seek independent professional advice before making any investment or taking any course of action towards investing. 

A copy of the valid prospectuses of the unit trust funds distributed by Citibank Bhd have been registered and lodged with the Securities Commission.  

Applications for unit trusts may only be made on forms of application available with the prospectuses. A copy of the prospectuses can be obtained from Citibank Bhd by calling (03)2383 8833, (04)227 6666 or (07)276 8833. 

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