The paper attempts to validate efficient market hypothesis in Indian stock market by examining the relationship between risk and return. The paper also examines the possibility of diversification effect on portfolio risk, which is the composite of market and non-market risk. The study relies on daily, weekly, and monthly adjusted opening and closing prices of BSE 100 composite portfolios for the period of June 1996 through May 2005. The findings suggest that the relationship between portfolio return and risk is very weak, based on daily return. It is moderate in the case of weekly return. However, portfolio risk and return exhibit a high degree of positive relationship when monthly return is used. Portfolio non-market risk shows a declining tendency with diversification.

An efficient capital market fully reflects the available information. It provides unbiased estimates of the underlying stocks, which result in eliminating the possibilities of making abnormal profit under conditions of certainty. Substantial empirical evidence supports the efficient market hypothesis in the developed countries. Widely quoted Capital Asset Pricing Models of Sharpe (1964), Lintner (1965), and Mossin (1966) describe how risky assets are priced in competitive capital market. By efficient capital market they mean that risky assets are priced according to risk and return preferences of investors. The return of well-diversified portfolio is composed of regular return (dividend) plus risk weighted return, i.e., appreciation/depreciation in the value of investment. Portfolio risk, on the other hand, is weighted average of market and non-market risk of the constituent stocks. Sharpe and Cooper (1972) argue that variations in stock returns are resultant of market and non-market risks.

Market risk is evolved by including factors such as interest rate, inflation, and foreign exchange rate. It affects the whole stock market; however, the degree of influence varies across the stocks. With the increasing presence of foreign institutional investors, Indian stock market has become responsive to international market forces. A change in the interest rate prevailing in the international market to a large extent can cause capital inflow or outflow from the Indian stock markets. Non-market risk, on the other hand, is specific to each stock. Variation in investors’ expectations to tangible or intangible factors of each stock can cause change in its value.

Sharpe and Cooper (1972) argue that diversification across the stocks results in decline of portfolio risk, thereby, reduction of non-market risk. As a result, market risk should be assumed as the proper measure of portfolio risk. In an efficient capital market, rational investors, being risk averse, will demand increasing return for increasing risk. They are ready to take extra risk only with the expectation of gaining extra risk premium. In bullish market, portfolio returns are likely to increase by purchasing the stocks with high market risk, and conversely in bearish market, losses can be reduced by holding stocks with low beta value. If this relationship holds true a perfect or efficient capital market will provide increasing return for increasing market risk. Further, diversification across the stocks will lead to the decline of non-market risk. This paper investigates this hypothesis.

IUP Journal of Applied Finance, Portfolio Performance, Indian Stock Market, Portfolio Management, Bombay Stock Exchange, BSE, Capital Asset Pricing Models, Efficient Market Hypothesis , EMH, Applied Finance, National Stock Exchange, NSX, Market Index Model.