Is the Risk-Return Tradeoff Hypothesis valid: Should an Investor hold Growth Stocks rather than Value Stocks?

Abstract

This paper will examine if smaller companies outperform large ones in the backwashes of the crisis, i.e. if growth stocks are better off than value stocks when investing. I will investigate how well the three largest companies from Nasdaq OMX’s small cap, mid cap and large cap managed to perform compared to the market index OMXSPI. Using the Capital Asset Pricing Model I will use the beta as a measure of risk to see if higher risk entails higher returns, as the risk-return tradeoff model assumes.

Three portfolios consisting of three companies each will be observed and compared. The samples observed will be: i) a portfolio consisting of the three largest companies at Nasdaq OMX small cap list, ii) a portfolio consisting of the three largest companies at Nasdaq OMX mid cap list and iii) a portfolio consisting of the three largest companies at Nasdaq OMX large cap list and an comparing index: OMXSPI. The three portfolios will be divided into two different measure groups: one where the three portfolios are equally weighted and one where the portfolios are weighted by its market capitalization, to investigate if there are any significantly large differences. Each one of the three portfolios will also be compared to an appropriate index.

The result supports the assumption of the risk-return tradeoff: the higher the risk, the higher the return. Given that the investor is willing to bear more risk, the return on the investment made will be higher. According to the research made I found that smaller companies do outperform larger ones, since the large cap portfolio had the lowest rate of return for the given time period. But the risk-return tradeoff assumption is not totally true: the small cap portfolio did not manage to outperform the mid cap, hence the best performance made after the crisis was by the mid cap portfolio. I therefore conclude that the risk-return tradeoff is partly true, that a mix of growth- and value stocks would generate the highest return and that more data need to be used to give more exact result.