Modern financial theory holds that high risk and high return go hand in hand. If you want to get more from your stock portfolio, you need to buy riskier equities. There’s just one problem with that, says Société Générale strategist Dylan Grice in a new research note: the evidence suggests quite the opposite is true.
Yes, history certainly shows “high risk has equated to higher return across asset classes”. If you look at very long-term returns in US markets, short-dated Treasury bonds have returned less than more volatile long-dated Treasury bonds. These have in turn returned less than equities, which have returned less than riskier small-caps. All that is exactly as expected. “But within asset classes, risk curves are curiously kinked.” The safest AAA-rated bonds have earned the same as the riskiest CCC-rated bonds. The best returns have come from middle-ranked bonds on the border between investment grade and non-investment grade.
The outcome with shares has been even more unexpected. One way to measure the risk of a company is with Piotroski’s F-score, a test that combines nine measures of financial health. A high F-score indicates a high-quality, low-risk stock. It turns out that firms with the highest F-score have delivered the best average returns, while those with a low F-score have been the worst performers. That’s despite the fact that high F-score stocks were more expensive. Far from embracing risk to get better returns, it seems investors should instead be willing to pay an even higher premium for quality.