Does Higher Risk Really Lead To Higher Returns?
Many widely accepted financial models are built around the premise that investors should expect higher returns if they are willing to accept more risk. However, will investing in a portfolio of risky stocks really help increase your investment returns over time? The answer may surprise you. Read on to learn about what is being dubbed the "low-volatility anomaly," why it exists, and what we can learn from it.
TUTORIAL: Risk And Diversification
The Low Down on Low-Volatility Stocks
If the modern portfolio theory holds true, a portfolio of risky, highly-volatile stocks should have higher returns than a portfolio of safer, less-volatile stocks. However, stock market researchers are discovering that this may not always be the case. A March 2010 study by Malcolm Baker, Brendan Bradley and Jeffrey Wurgler, published in the Jan./Feb. 2011 Financial Analysts Journal and entitled, "Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly," demonstrated that from Jan. 1968 to Dec. 2008 portfolios of low-risk stocks actually outperformed portfolios of high-risk stocks by a whopping margin.
The study sorted the largest 1,000 U.S. stocks monthly into five different groups, based on two widely accepted measures of investment risk. The authors ran the study once, using trailing total volatility as a proxy for risk, and again using trailing beta. Over the 41-year period, a dollar invested in the lowest-volatility portfolio of stocks grew to $53.81, while a dollar invested in the highest-volatility portfolio grew to only $7.35. The findings were similar when they grouped stocks based on trailing beta. Over the same period, a dollar invested in the lowest-beta portfolio of stocks grew to $78.66, whereas a dollar invested in the highest-beta portfolio grew to a paltry $4.70. The study assumed no transaction costs.
These results fly in the face of the notion that risk (volatility) and investment returns are always joined at the hip. Over the study period, a low-risk stock investor would have benefited from a more consistent compounding scenario with less exposure to the markets most overvalued stocks. (For a related reading on how volatility affects your portfolio, check out Volatility's Impact On Market Returns.)
Proponents of behavioral finance have presented the idea that low-risk stocks are a bargain over time, because investors irrationally shun them, preferring stocks with a more volatile, "lottery style" payoff. Backers of this school of thought also believe that investors have a tendency to identify great "stories" with great stocks. Not surprisingly, these highly touted "story stocks" tend to be among the markets most expensive and most volatile. Overconfidence plays a role here, too. As a whole, investors misjudge their ability to assess when stocks will "pop or drop," making highly volatile stocks appear like a better proposition than they really are. Even the so called "smart money" has a tendency to gravitate towards risky stocks.
Many institutional investors are compensated based on short-term investment performance and their ability to attract new investors. This gives them an incentive to pass up less volatile stocks for riskier ones, especially in the midst of a raging bull market. Whether it is bad habits or disincentives, investors have a tendency to pile into the market's riskiest stocks, which drive down their potential for future gains, relative to less volatile ones. Consequently, low-risk stocks tend to outperform over time.
Before You Bet the Farm on Low-Volatility!
Before you trade all of your technology stocks in for a portfolio of utilities, keep in mind that, like most stock market anomalies, this one probably exists because it is not easy to exploit. A study published in Sept. 2011 by Rodney Sullivan and Xi Li entitled, "The Limits to Arbitrage Revisited: The Low-Risk Anomaly," explored the viability of actually trading the low-volatility stock anomaly from 1962 to 2008. Over the 45-year study period, Sullivan and Li found that, "the efficacy of trading the well-known low-volatility stock anomaly is quite limited." Issues cited in the study include the need for frequent portfolio rebalancing and the high transaction cost associated with trading illiquid stocks. According to the study, illiquid stocks are where most of the abnormal returns associated with the low-volatility anomaly are concentrated.
There are a few other issues associated with investing in low-volatility stocks. Low-volatility stock investing strategies can suffer long periods of under-performance relative to the broader stock market. They also have a tendency to be heavily concentrated in a few sectors like utilities and consumer staples. (Among the methods used to measure volatility, specifically in technical analysis, is calculating average true range. Read more at Measure Volatility With Average True Range.)
The Bottom Line
The positive relationship between risk and expected returns may hold true when investing across different asset classes, but the same may not always be true when investing within a particular asset class, like stocks. While it is dangerous to assume that you can boost your investment returns simply by investing in a portfolio to risky stocks, it can be equally as dangerous to assume that researchers of the low-volatility stock anomaly have somehow discovered a silver bullet to achieving higher returns.
Stock investors shouldn't overlook the importance of consistency when attempting to compound their investment returns. They should also take into account that the stability of a company's stock price is often a reflection of the true quality of its underlying earnings stream.