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Robert Abbott
Robert Abbott
Articles (840)  | Author's Website |

High Returns From Low Risk: The Paradox Explained

Think of the old saying: It's not what you make, but what you don't lose

January 23, 2020

Low-risk investments outperform high-risk investments: That’s the case made by Pim Van Vliet and Jan de Koning in their 2016 book, “High Returns from Low Risk: A Remarkable Stock Market Paradox.”

In chapter two, they set the stage by discussing Van Vliet’s early investments, and a hard lesson learned. As a teenager in the early 1990s, he first invested his savings in a fund that paid 6%, and then jumped to one paying 8%. He knew about compounding and couldn’t wait for it to make him wealthy.

However, he grew bored with this slow growth and decided to invest in a Dutch aircraft maker, Fokker. Its stock price was low thanks to cyclicality and production costs that were too high. Nevertheless, its CEO had comforting words for potential investors. Despite the stock’s volatility, downward trajectory and financial distress, the teenaged Van Vliet decided to move a lot of his funds into it, at a price of 12 Dutch guilders ($7).

Despite the CEO’s assurances, the company did not recover and after the stock plunged to 4 guilders, he couldn’t take the bad news any longer and sold off his position. A couple of years later, the stock was gone altogether.

Obviously, Van Vliet had invested in a high-risk stock, one which was supposed to deliver above-average returns. And, what is a high-risk stock? In chapter three, the authors made a distinction between uncertainty and risk. Uncertainty refers to something that cannot be quantified; on the other hand, risk can be quantified, usually in terms of probabilities. As they put it, “Risk is uncertainty put into a number.”

In the investment universe, risk relates to potentially negative probabilities in which investors might lose some or all their money.

Volatility refers to measurements of price fluctuations in an investment, in a standardized way. Van Vliet and de Koning added that volatility is “quite persistent” over time; low volatility stocks will quite likely remain that way and high volatility stocks will continue to show high volatility.

But what if you bought a diversified portfolio of high-risk, high volatility stocks, rather than just one? Would that not provide higher returns overall?

To compare portfolios of low-risk and high-risk stocks, Van Vliet used a dataset that contained all the monthly closing prices of U.S. traded stocks from January 1926 to Dec. 31, 2014. That’s a period that covered the crash of 1929, the Great Depression of the 1930s, World War II, the dotcom bust and the financial crisis of 2008. With 88 years of history, most temporary effects and pure luck fade into the background. Only the 1,000 largest companies (by market cap) for each year were chosen.

Without getting into more detail about the research, the results were dramatic:

  • An investment of $100 in the high-risk portfolio on Jan. 1, 1926 would amount to $21,000 by Dec. 31, 2014.
  • An investment of $100 in the low-risk portfolio, on the same date in 1926, would grow to $395,000 by the end of 2014. That’s 18 times more than the high-risk portfolio.

In percentage terms, the high-risk portfolio averaged 6.4% per year, while the low-risk fund averaged 10.2%. That’s an annual difference of 3.8%, which turns out to be a very big difference over almost nine decades. Note that this is compounded annual growth, in which each year’s gains are reinvested in the same stocks.

Van Vliet and de Koning argued that the low-risk portfolio came out ahead because it lost less during the bad years. For example, by the time the market hit bottom in 1932, the original $100 investment in the high-risk group was worth only $5, while the low-risk portfolio was worth $30.

One of the arithmetical truisms that investors face is this: If your portfolio loses 50% of its value, you need a 100% return to get back to even. The arithmetic gets harder as the losses increase, so an 80% loss requires a 500% return to get back to the value of the original investment.

What then if we skip the worst of the Great Depression and start the portfolios in 1932? The authors reported the low-risk portfolio would still win because there have been several more serious stock market plunges since then, a couple of them were listed above.

These results all clash with the theory put forward by proponents of the efficient market hypothesis, and the implication that the only way to pull in above-average returns is to take on more risk. What's more, many market players think it only makes sense that investors should be rewarded for taking on extra risk.

Van Vliet and de Koning responded by referring to the fable of the tortoise and the hare. The tortoise is expected to lose the race to the much faster hare. Nevertheless, the tortoise does race, moving slowly and steadily. The hare dashes out ahead of the tortoise, confident it will win easily. It’s so confident it takes a nap and ends up being beaten by the tortoise.

That’s the paradox at the core of this book, that a low-risk portfolio beats a high-risk portfolio because it is slow and steady. It never races ahead, but it can recover from market declines more quickly than the high-risk portfolio.

Consider just the S&P 500’s loss of 38.5% in 2008. Both high-risk and low-risk portfolios had to recover, and while the authors don’t provide the amounts of the losses in that year, we can be quite sure that the high-risk stocks had a much steeper path to recovery.

Conclusion

As with low-risk portfolios and tortoises, Van Vliet and de Koning are making a slow and steady argument for their theory that higher returns come from low-risk portfolios.

In chapters two and three, they introduced the distinction between risk and uncertainty, and provided some top-line results and conclusions from Van Vliet’s own research.

His study confirmed that low-risk portfolios deliver better returns than high-risk portfolios. They attribute that seemingly paradoxical finding to the higher losses suffered by higher-risk portfolios. And because the financial markets keep suffering serious losses from time to time, the higher-risk portfolios cannot keep up with the lower-risk portfolios.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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