Applied Finance and Accounting Vol. 7, No. 1, February 2021 ISSN 2374-2410 E-ISSN 2374-2429 Published by Redfame Publishing URL: http://afa.redfame.com 1 The Effect of Systematic Risk and Previous Period Returns on Portfolio Selection Cem Berk 1 , & Bekir Tutarli 2 1 Kirklareli University, Turkey 2 Independent Researcher, Turkey Correspondence: Cem Berk, Kirklareli University, Turkey. Received: September 14, 2020 Accepted: October 5, 2020 Available online: October 22, 2020 doi:10.11114/afa.v7i1.5051 URL: https://doi.org/10.11114/afa.v7i1.5051 Abstract There are many techniques to determine investable set of portfolios given return data of assets. However, the theoretical results do not always point out the best portfolios in practice. This is due to the fact that financial dynamics are so difficult to be modelled and this requires many assumptions. The investor may have some preferences to select portfolios. In this study, two selection criteria are proposed to be applied in a mean variance optimization. These criteria are beta coefficient which is a measure of systematic risk and previous period return. The study has an empirical analysis applied on Istanbul Stock Exchange. The findings of the study confirm that these selection criteria may be used to obtain investable portfolios. The analysis with beta selection criteria reveal that the portfolio with lowest 5 beta coefficients is the best alternative. This means that the advantage of low beta which is a natural hedge when stock values declineis superior to diversification benefits of adding new stocks. The previous period return analysis suggest two alternative portfolios. In addition, one of these portfolios generate higher return than the portfolio selected with beta selection criterion. This is also a higher risk portfolio. Therefore the decision is based on risk profile of the investor. This research offer to add selection criteria to the standard approach which is beneficial for academic and practical purposes in portfolio management. Keywords: beta selection criteria, mean variance optimization, previous period return, portfolio theory, systematic risk JEL Classification: D81, G11, G321. 1. Introduction A stock risk is composed of systematic and unsystematic components. Systematic risk is all the risks that is available for all stocks for portfolio such as interest rate risk and inflation. Unsystematic risk (or as often called idiosyncratic risk) is the risk associated with a single stock such as management performance, leverage, or operational risks. These risks together with return data is used to construct portfolios in portfolio management practice. Since Markowitz (1952)- who developed what is known today as Modern Portfolio Theory(MPT), investors try to minimize unsystematic risk of a portfolio. He showed mathematically that unsystematic risk isn’t just sum of that of all stocks in the portfolio but also a covariance matrix plays a role. In other words, the lower the covariance between stocks, the lower the portfolio risk. Modern portfolio theory is also applied in this research. The motivation of this paper is to see if it is possible to construct portfolios based on beta (a measure of systematic risk) and previous period returns of stocks. If this is possible, then stocks that generate the best portfolios based on systematic risk and previous period return can be determined. By adding stocks to a portfolio, diversification is obtained. That is a risk reduction in the portfolio. However, this is limited to the systematic risk, beyond which the variance of the portfolio cannot be further reduced. Systematic risk is measured by the beta coefficient. According to Sharpe (1988), beta coefficient measures the sensitivity of individual stock return to the market return. Beta can be computed with any of the following formulas.