For a stakeholder, risk and return are essential considerations in the investment decision-making process. Investors try to minimize systematic (market) and unsystematic risks and optimally choose stocks yielding favorable risk-return trade-off (Aliu, Pavelkova, & Dehning, 2017). Risk in this context is defined as the variability that could occur in the cash flow of the investment. While the return is the reward which the investor gets for bearing this uncertainty. Securities or stocks having low risk tend to yield fewer returns, like government securities or bonds. However, long-term high-risk stocks tend to provide more returns (Gupta, 2012).
The above figure shows the existence of a direct relationship between risk and return. Based on the attitude of the investor towards risk, the stock would be selected for investment.
Methods to examine the rate of risk-return for a stock
Krishnsprabha & Vijayakumar, (2015) based on their analysis of the Bombay Stock Exchange that included stocks of:
- consumer goods and,
- pharmaceutical sectors;
stated that the decision-making process of an investor is dependent on risk and return. Thus, in order to understand the behavior of an investor, it is essential to conduct a risk-return analysis. Krishnsprabha & Vijayakumar stated that return for a period can be computed using the average of return at each sub-period. However, in order to measure risk, either the value of beta (β) can be computed or variance or standard deviation of return can be used. Gorbunova, (2016) supported the method stated by Krishnsprabha & Vijayakumar and listed out the coefficients used for measuring risk i.e.
|Beta (β)||Depict the change in return from certain stock with respect to change in market price.|
Wherein, n: number of observations; X: profitability index; and Y: return on stocks
|Alpha (α)||Represents the average change in the prices of a company’s shares.|
Wherein, β: beta coefficient; n: number of observations; X: profitability index; and Y: return on stocks
|Standard deviation||Shows the magnitude of market risk|
Wherein, α: alpha coefficient; β: beta coefficient; n: number of observations; X: profitability index; and Y: return on stocks
|Correlation Coefficient||Explains the relationship between the market index return and return from a certain share|
Wherein, n: number of observations; X: profitability index; and Y: return on stocks
Trend based analysis of stocks
Gautami & Kalyan, (2018) compared the risk and return of selected stocks of Indian stock exchange. Their analysis stated that in order to compare the performance of stocks it is essential to observe the movement in the prices of stocks. For this, trend-based analysis needs to be done for the movement in the prices of the shares. The formula used for tracking this movement is as follows.
This method of movement analysis was also supported by Gupta, (2012) who stated that the trend-based analysis of these movements in stock price helps in keeping a record of the earning of an investor considering the risk born by them. Shobha & Navaneeth, (2017) further stated that the trend analysis of the returns would help in determining the rate of the volatility of the returns.
Aliu et al., (2017) supported this trend-based risk-return trade-off analysis. They stated that by comparing graphically the weighted return and standard deviation of the returns, the stocks risk-return trade-off could be compared. The presence of a weighted return graph above the risk (standard deviation) shows that stock provides compensation for the risk borne by the investors.
Momentum based analysis of stocks
Each investor focuses on firstly analysing the movement of the stocks in order to determine the possibility of profitability. An investor focuses on minimising its risk and for having the information about the movement of stock prices in past, it is essential to track its movements (Agrawal, Jindal, & Pilla, 2010). Study of Agarwal, Jindal and Pilla examined the movement of stocks with 15 days and 50 days moving average using the below shown formula
This comparison enables assessing the performance and volatility of stocks. Larsen, (2010) further emphasised on the relevance of momentum analysis. He stated that by using the moving average at different time periods, one can predict the future movement of stocks.
Vaidya, (2018) worked on the stochastic oscillation method for identifying the nature of stocks. Performing a momentum analysis with a 3-month average, Vaidya stated that with the formation period of 3 months the short term comparison between the performance of the stock could be done. Hence, momentum-based analysis of stocks tends to provide information about the historical position of the stocks and predict the future movement of stock prices.
CAPM based analysis of stocks
Parmar, (2016) focused on the Capital Asset Pricing Model (CAPM) based method of examining the variability of the returns. Studying the behavior of stocks, Parmar compared the market return with the risk-free return. This comparison of the risk-return helps in determining whether the investment in a given stock is optimal or not. Rui, Rasiah, Yen, Ramasamy, & Pillay, (2018) further tested the link between the risk and expected return using CAPM. Analysis of risk and return relationship using CAPM tests examines the stated direct linkage between risk and return. The expected return could be computed using the below formula
Furthermore, by comparing the actual return of the stocks with the expected return, the CAPM analysis helps in predicting the nature of stocks by classifying it into under-priced, over-priced, and neutral category. With the opportunity of growth in the under-priced stocks, investors prefer to invest in these stocks (Sukono et al., 2018). Kumar, (2020) supported this by comparing the return at different holding period. CAPM analysis of stocks herein states that as the holding period of the stocks increases, the risk associated with it also decreases. Though the return rate varies with the change in holding period but mostly the stocks for shorter period having high risk tended to yield higher return.
Combination of trend, momentum and CAPM based analysis is the optimal method of examining risk-return trade-off
An optimal decision of investment is dependent on the analysis of the past performance, current movements in prices, and the future prediction of the stock position. Together trend, momentum, and CAPM analysis help study the behaviour of stocks along with predicting the movement of stocks in the future.
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- Risk tolerance by stocks categorization using ratio analysis - September 10, 2020
- Methodology to analyze the dynamic behavior of investors in the Indian stock market - September 4, 2020
- An introduction to stock market trend analysis - July 31, 2020