Does higher risk really lead to higher returns?

Wednesday, 25th April 2012

In March 2010, a study showed that from January 1968 to December 2008, portfolios of low-risk stocks outperformed portfolios of high-risk stocks by a huge 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 - volatility and trailing beta. Over the 41-year period, one 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 study assumed no transaction costs These results challenge the notion that risk (volatility) and investment returns are always joined at the hip.

It is sometimes argued that low-risk stocks are a bargain over time, because investors irrationally shun them, preferring stocks with a more volatile payoff and investors have a tendency to identify great "stories" with great stocks which tend to be among the most expensive and most volatile.

Overconfidence plays a role as 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. Because 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.

A 45-year study published in September 2011 explored the viability of actually trading the low-volatility stock anomaly from 1962 to 2008. It found that the efficacy of trading the well-known low-volatility stock anomaly is quite limited Low volatility stocks have a tendency to be illiquid and heavily concentrated in sectors like utilities and consumer staples thus requiring frequent portfolio rebalancing and with higher transaction costs.

The positive relationship between risk and returns may hold true when investing across different asset classes, but 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 dangerous to assume that the low-volatility stock anomaly is a silver bullet to achieving higher returns.