Continuing further from my previous article about Stock picking skills, whether we follow the technical analysis or fundamental analysis, all that is required for us is luck. If we are lucky, our stock selection even in penny stocks will turn out to be profitable. If we are unlucky, our investment even in so called bluechip companies will end up in a loss, even in long run. Your mutual fund manager cannot do anything better – instead you end up paying commission to him.
Anyways, so what’s the best way to select stocks?
Well, there is one good way to evaluate – very basic and easy to understand. Let’s look at it.
For any investment, there are 2 attributes. First one is the return, while the second one is the risk. The higher return you expect, the higher risk you will have to take. However, the reverse is not true: Just because you have taken higher risk, it does NOT mean that higher returns are GUARANTEED.
How do we quantify the risk and return? Suppose you want to select between the 2 stocks: Satyam and Infosys. These 2 stocks belong to the same IT sectors and hence make a good case for someone willing to invest in the IT sector stocks. This calculation can be also used across stocks of different sectors.
How do you proceed? One very simple way is to look at historical returns and historical risk for the same investment horizon. Let me take last one month as investment horizon: 1 July 2007 to 31 July 2007.
We will look at the closing prices of these 2 stocks for the 1 month long investment horizon.
| Date | Satyam Close | % Gain | Formula | Infosys | % Gain | |
| 02-Jul-07 | 466.7 | | | 1943.85 | | |
| 03-Jul-07 | 473.1 | 1.37% | =(473.1-466.7)/466.7*100 =1.37% | 1947.4 | 0.18% | =(1947.4-1943.85)/1943.85*100 |
| 04-Jul-07 | 471.25 | -0.39% | This formula basically calculates the daily percentage gain over previous day | 1931.05 | -0.84% | |
| 05-Jul-07 | 464.85 | -1.36% | 1916.8 | -0.74% | | |
| 06-Jul-07 | 488.1 | 5.00% | 1971.8 | 2.87% | | |
| 09-Jul-07 | 492.4 | 0.88% | 1993.75 | 1.11% | | |
| 10-Jul-07 | 497.75 | 1.09% | We make this calculation for all the days of our investment horizon | 2020.5 | 1.34% | |
| 11-Jul-07 | 480.7 | -3.43% | 1929.65 | -4.50% | | |
| 12-Jul-07 | 478.35 | -0.49% | 1922.2 | -0.39% | | |
| 13-Jul-07 | 493 | 3.06% | 1939.8 | 0.92% | | |
| 16-Jul-07 | 481.75 | -2.28% | | 1935.85 | -0.20% | |
| 17-Jul-07 | 489.5 | 1.61% | | 1938.55 | 0.14% | |
| 18-Jul-07 | 481.75 | -1.58% | | 1944.55 | 0.31% | |
| 19-Jul-07 | 486.55 | 1.00% | | 1996.5 | 2.67% | |
| 20-Jul-07 | 479.6 | -1.43% | | 1986.25 | -0.51% | |
| 23-Jul-07 | 491.15 | 2.41% | | 1947.8 | -1.94% | |
| 24-Jul-07 | 517.6 | 5.39% | | 1975.1 | 1.40% | |
| 25-Jul-07 | 487.85 | -5.75% | | 1988.85 | 0.70% | |
| 26-Jul-07 | 494.85 | 1.43% | | 2034.35 | 2.29% | |
| 27-Jul-07 | 472.5 | -4.52% | | 2007.85 | -1.30% | |
| 30-Jul-07 | 475.15 | 0.56% | | 1986.4 | -1.07% | |
| 31-Jul-07 | 480.5 | 1.13% | | 1975.8 | -0.53% | |
| | Average | 0.18% | Average of all daily % returns | | 0.09% | Average of all daily % returns |
| | | |||||
| | Standard Deviation | 2.80% | Standard Deviation of all daily % returns | | 1.67% | Standard Deviation of all daily % returns |
| | | |||||
| | Sharpe Ratio | 6.30% | =Average/Std. Deviation | | 5.45% | |
What we have done in the above table is as follows:
We first get the data for both these stocks – by downloading it from the company website or exchange website.
We take the daily % returns for each day by calculating it as given in the table with the above formula. We do this for each day (it’s pretty easy of you know how to use formulas in Excel sheet.)
Then, we calculate the simple average for all the % daily returns. This figure (0.18% for Satyam and 0.09% for Infosys) indicates the AVERAGE DAILY RETURN on these stocks over the investment horizon. This constitutes our RETURN component.
Then, on the same data set, we calculate the Standard Deviation (use the excel function STDEV). Standard deviation indicates the average fluctuation in the stock price on a daily basis for the investment horizon. What this means? It actually indicates that by what percentage the stock price can move, on a daily basis. For satyam, it is 2.8% while for Infosys, it is 1.67%. This means that Satyam stock prices are more volatile or fluctuating, as compared to infosys stock prices. On an average, Satyam may go up or down by 2.8% on a daily basis, while Infosys may go up or down by 1.67% on a daily basis. This volatility constitutes our RISK component.
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