Does skewness help in better investment decision making?

Abstract

Purpose The purpose of this paper is to examine the significance of skewness in maximizing the investor utility using the daily data for eight sectors listed on the National Stock Exchange of India. Design/methodology/approach The analysis is carried out in three different steps. In the first part, the author analyzes the monthly stock returns and the important financial ratios – price-to-book (PB) ratio, price-earnings (PE) ratio and dividend yield (DY). Second, the author tests the sector-wise return predictability using Westerlund and Narayan (2012) flexible generalized least squares estimator. Third, the author compares the mean–variance–skewness (MVS) utility function with the mean–variance (MV) utility function. Findings The author forecasts the sectoral stock returns using three financial ratios – PB ratio, PE ratio and DY – as predictors. The results indicate that sectoral stock returns are significantly predicted by these financial ratios. The author then formulates trading strategies by including skewness in the utility function and finds that the investor utility is high when the utility function includes skewness as opposed to when the skewness is excluded. Originality/value The author extends the MV utility function to the MVS utility function and shows that the Indian stock market is more profitable when the investor uses a MVS utility function which highlights the main contribution to the literature.