type of stock question question

aurific

One should never invest in the following type of stocks
a. stocks with negative expected return
b. stocks with negative beta
c. stocks with negative sharpe ratio
d. None of the above.


Isn't A and C the same thing because negative expected return yields a negative sharpe ratio

rgonzalez

It's C. If the expected return is negative, you can add value by shorting the stock. The Sharpe ratio is a measure of performance (either ex-post or ex-ante), you should pick the stock with the highest sharpe ratio.

JRossSter

I don't get it... Couldn't you invest in a stock with expected return lower than risk free return (i.e. negative sharpe ratio) if the stock's beta was 0 or negative? It would reduce the overall risk...

smartpants

SR is a measure of performance per unit of risk. You should NEVER invest in a stock that has negative shape ratio because the performance of the RFR is superior.

If SR is zero, it means that you are investing in RFR, below zero means that investing in the stock doesn't produce any value since the SR of investing in the RFR is higher.

You can always short a stock with negative expected performance. Hope it's clear.

evolsteevol

Thanks mik82.. It does make a lot of sense... What is confusing me is that what if the beta of the security is negative... wouldn't that make a case for the stock since it may reduce the overall risk.. Does a stock with negative beta necessarily have a positive SR? I am new to this field so I apologize if I am missing something basic here...

koba

Beta has nothing to do with Sharpe Ratio, the forumla of SR is (E(R)-RFR)/st dev. Where does beta fits it?

A stock with negative beta can have a positive expected return ONLY if the expected return on the mkt (or market risk premium) is negative. (look at CAPM formula).

Anytime I am unsure about something, I look back at the formula to find a solution. It helps me understand.

johnnyBuz

But why can't you short the stock with negative SR as well as with negative exptected return? If the stock produces significant negative excess return per unit of risk, you would be supposed to benefit from taking short position in this stock.