Here’s what you probably think: that the more risk you take, the better a reward you will get; high risk (taking on high levels of uncertainty) equals high returns.
That’s the key thinking behind the ‘efficient market’ theory at least – and therefore what you probably think if you have ever been taught finance.
Here’s the truth: low risk stocks consistently provide higher returns than high-risk stocks.
Here’s why, and how you can take advantage.
The proof
This surprising conclusion is the result of a recent study out from two US analysts Nardin L Baker and Robert A Haugen.
The two looked at 33 different markets (21 developed and 12 emerging) between 1990 and 2011. First, they computed the volatility of total return for the stocks in each country. Then they divided them into deciles and looked at the relationships between the deciles.
The result? “In the total universe and in each individual country low risk stocks outperform. The relationship with respect to Sharpe ratios is even more impressive.”
Overall, the least volatile decile of developed-nation shares generated total returns averaging 8.7% a year, while the most volatile produced negative 8.8% a year. If you just look at the US the comparable figures were a positive 12% and a negative 7%.
There are a few problems with the data used in the study, the main one being that 21 years is never enough to analyse anything in markets – and it particularly isn’t long enough in this case given the extraordinary events of the last 15 years.
All numbers on all things are, for example, skewed by the tech bubble of 1999/2000 and, of course, by the financial crisis of the last few years that bubble spawned. However, it is probably still fair to say, as Haugen does, that their paper shows up a “remarkable anomaly” and “contradicts the very core of finance”.
These two aren’t the first to make the point. Several earlier studies have concluded something similar. You can read here the views of Lazard’s Susanne Willumsen on the matter.
And MoneyWeek favourite Dylan Grice hit the nail on the head a few weeks ago on what he calls the ‘boredom discount’.
Add it all up, and it is getting close to being conclusive.
How you can benefit
What does it mean in practice? It suggests that we overvalue growth, that we overvalue excitement, that we give risk far too much status, and that all the forms wealth managers and IFAs constantly make us fill in about our risk profile are nonsensical.
If Baker and Haugen are right (and expect intense retaliation from the financial industry any day now) you don’t need to agree to take on extra risk to make good long-term returns, you need to demand that you do not. “High risk equals low returns”, says Grice.
You might, if you are in an academic mood, look at this idea in conjunction with this paper that suggests something equally interesting. The point thrown out here is that fund managers who want to be considered successful are forced by the circumstances of their industry to indulge in overly high-risk behaviours in order to make it big. And, of course, to pick up a couple of the big bonuses and performance fees that really make life in the financial markets worth living. More on this here.
That is exactly the wrong thing to do, so most risk taking managers eventually crash and burn (falling out of all performance measurements as they do so and creating the ‘survivor bias’ that so confuses everyone).
However, a few others – mostly by luck alone – find they hit the jackpot over and over again with their high-risk behaviour. Their approach is appalling, given what we know to be the parameters of long term investing success (the tortoise beats the hare). But they still end up our gurus and our stars. The “best,” as the paper has it, are in fact symptomatic of the worst.
What to buy now
What all this probably tells us is that, should you be tempted to pile your cash into the riskiest thing you can see in Europe on the basis that when it pops it will really pop, you should probably go and sit in the sun for a while instead. Leave the crazy stuff to the world’s wannabe star managers.
Instead, make a start on ensuring your own financial future by going for low volatility value. That means going for all the stocks we’ve been steering you towards for the last few years: defensive stocks with good franchises and good cash flow, all bought at reasonable prices.
Three example include pharma giant GlaxoSmithKline (LSE:GSK), British American Tobacco (LSE:BATS) and Domino Printing Sciences (LSE:DNO). For more on these, take a look at my colleague Phil Oakley’s recent article, Six British firms to buy now.
This type of investing is boring of course. But just because other people undervalue boredom doesn’t mean we have to too.
• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .
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