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Use these two tools to look for less risky, promising stocks
BY SAMEER BHARDWAJ, ET BUREAU | UPDATED: DEC 10, 2018, 09.49 AM IST Post a Comment

Investment in equities is prone to two kinds of risks: internal and market risks. You can
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reduce or eliminate internal risks by allocating capital across different stocks or sectors.
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But, market risks, owed to macroeconomic or global factors, cannot be reduced or
eliminated by the investor.

Standard deviation is a common statistical tool used to estimate the total (internal plus market) risk of a stock or an index. It is used by
financial analysts to estimate the range within which a stock or an index returns are likely to fall.

The basis of such estimation rests on the assumption that financial variables, such as stock returns or PE ratios, will frequently fall close
to their average, and deviations beyond the upper or lower limits—as defined by standard deviation—are very unlikely. In addition, the
data is assumed to follow a symmetrical pattern, which means that half the time a stock return will be above its average, and half the
time it will be below average.

However, financial markets often diverge from the assumption of symmetry. The reasons for such divergence is the availability of
additional information to one of the parties (buyer/seller) involved in the stock market transaction. Such information could be related to
the past, present or future performance of a stock.

For example, the seller or buyer may have inside information regarding the future plans of a company, enabling him to judge whether the
stock is over- or undervalued. The asymmetrical pattern displayed by a stock’s returns makes predictions of risk and return unreliable. It
can result in misleading inferences that are based on the combination of average returns and standard deviation.

Skewness is used as an alternative risk measurement tool when the data is exhibits asymmetrical distribution. Skewness can either be
negative or positive. A stock with negative skewness is one that generates frequent small gains and few extreme or significant losses in
the time period considered. On the other hand, a stock with positive skewness is one that generates frequent small losses and few
extreme gains. If a stock’s return follows a normal distribution pattern, then their will be no skewness.
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The other abnormality that is witnessed in financial data is the possibility of extreme returns, technically termed as kurtosis. It serves to
measure risk, as the abnormal returns on some instances could go beyond 3-times the standard deviation limit, according to the theory
of normal distribution.

Ignoring such extreme observations can create risks that are not captured by financial models based on normal distribution. When data
follows normal distribution, the kurtosis has a value of three. Value greater than three means higher instances of abnormal returns,
whereas low value of kurtosis (less than three) implies fewer instances of abnormal returns.

Skewness and kurtosis are derived using the statistical concepts of moments of distribution. Although the concepts are difficult to
comprehend for the lay investor, you can easily calculate skewness and kurtosis using the MS excel functions Skew and Kurt.

We analysed the data for the constituent stocks of BSE500 index and used weekly returns data for each of these 500 stocks for the past
two, three and five years. Then, we calculated the skewness and kurtosis values of these 500 stocks and observed that stocks with high
positive skewness and low kurtosis outperform the stocks that display negative skewness and high kurtosis. In the 5-year study period,
the outperformance was more than 3.5-times.

In the 2- and 3-year study periods, stocks with positive skewness and low kurtosis outperformed the BSE500 index by a substantial
margin. Also, returns from stocks with positive skewness and low kurtosis were extremely positive in certain weeks and witnessed less
abnormal returns during the study period. On the other hand, returns from stocks with negative skewness and high kurtosis were
extremely negative in certain weeks with more instances of abnormal returns.

Low-risk stocks have outperfomed peers

Average point-to-point returns are from 28 Nov to 28 Nov for the 2-, 3- and 5-year periods, starting 2016.

Positive skewness, low kurtosis promise high returns

Analyst ratings and target prices from Bloomberg. BSE500 stocks considered. 5-year returns are point-to-point absolute returns between
28 Nov 2013 and 28 Nov 2018. Current prices as on 3 December 2018. Data source: ACE Equity and Bloomberg.

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