(2)-Stock Picking Parameters and Techniques: Continued – Part II

This is part II of the article Stock Picking Parameters and Techniques: Continued – Part I. Please read the first part before proceeding with this one


So, we look at maximizing the RETURN component and minimizing the RISK component. Hence, we take the so-called Sharpe Ratio, which is defined as (Return divided by Risk) or (Average/Std. deviation *100). Since we aim to maximize the returns and minimize the risk, we look for a higher value of Sharpe ratio.

In this case, Satyam has a Sharpe Ratio of 6.3% while Infosys has a Sharpe Ratio of 5.45%. This means that historically, over the past one month, Satyam has been better than Infosys in terms of Return and Risk.

Another thing to note is that the returns of Satyam (0.18%) is double than that of Infosys (0.09%). However, Risk of Satyam is also higher (2.8%) to that of infosys (1.67%).
This also confers with our “High return, High Risk” concept.

So, in essence, looking at Sharpe ratio will give a pretty good idea of what the stock has been doing and how volatile or stable it has been. The calculations can be stretched for years and decades, and the percentage returns can be calculated on weekly, monthly, quarterly or annual basis. A simple rule that is followed is match the historical period with your investment horizon. Meaning, if you want to invest for 3 year long horizon, make calculations for past 3 years.

You can do this calculation for any stock, any Mutual fund or index fund or ETF, or virtually any instrument that your want to anlayse.

However, Sharpe ratio is not fool-proof. The biggest problem is that the calculations are based on historical prices and there is no guarantee that the same will be performed over next horizon in future. But as compared to other figure like EPS, balance sheet calculations, etc. this makes more sense because it is calculated from the market prices. The figures presented in reports and balance sheets can be goofed up, while the market pricing give a better precise estimate.

Ultimately the call is yours. Hundreds of parameters are used in the world of finance. Sharpe Ratio is just one of them and has been effective atleast in terms of estimating the market fluctuations and returns over historic periods. Personally, instead of getting into stocks, I would prefer ETFs, as the standard deviation (risk) of ETF is pretty low compared to stocks. Sharpe ratio of an ETF would be better than that of individual stocks. Moreover, ETFs will never go bankrupt, the individual stocks may be out of business.


A note for equity investors: It has been historically proven that equities give better returns in the long run. So go ahead and invest in equities (Stocks, Mutual Funds, Index Funds, ETFs, etc) as per your need and risk appetite. I am NOT advising you to stay away from them. What I am advising is that set a target and an investment horizon. Exit when the target is achieved, don’t be greedy as that may result in losses.
For e.g., say you want to plan for your retirement and have an investment horizon of 30 years. You are ready to take the risk in stocks and want to invest 1 Lakh each year. So for 30 years, your total investment would be 30 lakhs. Suppose you target a maturity value of 2 Crore Rs. at the end of 30 year long horizon. Suppose, due to excellent Bull Run in the stock market, you managed to reach the target in just 20 years time. At this time, exit from the stock market. Don’t keep on accumulating money in stocks. Take the 2 crore out of stocks and put it in the bank and let it earn bank interest. Atleast your retirement income of 2 crores is safe. This will prevent you from the situation that may collapse the value of your stock investments in case the price fall sharply in last few years of your investment horizon.
For the remaining 10 years, keep on investing your 1 lakh in stocks and let it be exposed to market pricing. Atleast your retirement money of 2 crore will be safe.

That is what is required in investment – Purpose based investments, and target based capitalization. It is tempting to carry on investments in equities when you see that it is growing leaps and bounds – target of 2 crores reached in just 20 years as compared to the estimated 30 years. The failure & loss comes due to greed as there is uncertainty about the investment horizon and when to exit. Have a target in mind and things will work smoothly.


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You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.