Relationship between ‘risk’ and stock returns Mayur Agrawal Varun Agrawal Debabrata Mohapatra Sung Kyun Park Vikas Yadav

Objective  Does one need to take higher ‘risk’ to obtain higher returns?  CAPM model suggests so.  We investigate this hypothesis with real stock data.

Experimental Setup 1 st Jan st Dec 2008 Current Time K months N months  Duration of experiment 1 st Jan 1962 – 31 st Dec 2008  Update S&P 500 member list every K months.  Find the measure of risk for each stock in the list using past N months of historical data.  Sort the stocks based on risk values.  Form P portfolios.  Hold these portfolios for K months.  Compute the K month return based on actual stock values.  Readjust the portfolios every K months.  In case a company gets delisted, all its investments for the holding period are transferred to benchmark portfolio (S&P 500). Default Parameters: N = 60, K = 12, P = 10

Risk 1: Beta Conventional Wisdom: “To get higher returns, invest in stocks with higher beta.” Relative Return

Possible reasons for discrepancies in the plot  Exhibit 4 uses 600 ‘largest blue chip’ companies. They are large companies, with dividends, stable earnings and no extensive liabilities.  We use S&P 500 companies for all our analysis. Explanation :1 Explanation :2  Exhibit 4 does not mention the benchmark portfolio used for calculating relative return.  We use S&P 500 value weighted index as our benchmark portfolio. Explanation :3  There are bugs in our code. We are working on it to cross verify it.

Relative Return Risk 1: Beta(contd…)

Risk 2: Volatility Conventional Wisdom: “To get higher returns, invest in more volatile stocks.” Relative Return

Risk 3: Market Capitalization Conventional Wisdom: “To get higher returns, invest in stocks with lower Market Cap.” Relative Return

Conclusions  Conventional wisdom about beta and volatility are wrong.  Investigate portfolios with both low market cap and beta values for possible better returns.