The Cross-section of Return and Risk Relationship: New Evidences from Portfolio Diversification Strategies
Posted: 8 Jan 2020
Date Written: October 17, 2019
In recent decades, low-risk stocks provide higher returns than riskier stocks. This contradicts a well-established market theory of higher risk-higher return. The distorted relationship between risk and return over the last few years has been attributed to factors such as the risk aversion tendency among investors and the steadily growing practices of index investing by fund managers. Motivated by the emerging theory of upended risk-return relationship, we argue that the positive risk-return relationship hypothesis is true to a certain level of risk, however, beyond that threshold, the relationship between risk and return breaks down and they behave independently. We argue that for lower and moderate levels of risk, the returns are positively correlated and compensate for the incremental risk undertaken by investors, however, when the risks tend to be substantially higher, the return behaves independently irrespective of changing risk levels. Such a situation provides investors and risk managers to observe riskiness in the market very closely to formulate their investment choices. Investors would refrain from taking risky positions when the market seems to be very volatile as this might necessarily provide returns commensurate with the higher risks.
Keywords: Portfolio diversification, Multi-factor model, Indian stock market
JEL Classification: G12, C89
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