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Robert Abbott
Robert Abbott
Articles (799)  | Author's Website |

High Returns From Low Risk: Goldilocks for Investors

Adding a little risk to a low-risk portfolio may generate the best returns

January 24, 2020

Low-risk portfolios outperform high-risk portfolios because the low-risk group suffered fewer and less severe losses. That was the conclusion of chapter three of the 2016 book, “High Returns from Low Risk: A Remarkable Stock Market Paradox.”

But authors Pim Van Vliet and Jan de Koning weren’t finished when they explained how, paradoxically, low-risk stocks generated greater returns than high-risk stocks. In chapter four, they went on to find a Goldilocks position.

In the previous chapter, Van Vliet had used a dataset of stocks between January 1926 and December 2014 and ranked the 1,000 largest companies on the U.S. stock markets each year by volatility (the proxy for risk). He then compared the 100 least volatile (low-risk portfolio) and the 100 most volatile (high-risk portfolio) stocks. This was the result:

  • The low-risk portfolio generated an average of 10.2% per year (compounded) over the 88 years.
  • The high-risk portfolio produced an average of 6.4% per year (compounded) in the same period.

So low-risk, low volatility brought in an average of 3.8% per year more than high-risk, high volatility. The reason? Because of frequently appearing market corrections that depressed the high-risk group more than the low-risk group. After each correction, the high-risk stocks had to climb a steeper slope to get back to where they started.

Based on that relationship, as outlined in chapter three, the results indicate a negative relationship between risk and return, and as the authors told us, this is a case of the tortoise beating the hare. But those are just the two most extreme portfolios; would that negative relationship survive if all stocks were considered?

That question is the crux of chapter four, where Van Vliet and de Koning argued there is still more to glean from the former’s research. Instead of focusing on just the 100 least and most volatile stocks each year, he divided the 1,000 stocks into 10 groups of 100, again based on volatility.

When he charted those 10 portfolios. he found they produced an arc, rather than a straight line (which had to be the case when there were only two portfolios). On the arc, this is what you see:

This chart also provided a more nuanced framework for risk and return, somewhat as we would expect—but only up to a certain point. While the original two portfolios (1 and 10) continue to show the same relationship as in the previous chapter, we now see that there is value in adding some risk or volatility to a portfolio:

Van Vliet and de Koning observed that most high-risk portfolios, including 8 and 9, as well as 10, brought in lower returns than most low-risk portfolios. In other words, the high-volatility portfolios do not reward investors for taking on more volatility or risk. More risk and less return; that’s not among the aspirations of any investor.

On the other hand, adding volatility to lower-risk portfolios improved returns, specifically:

  • Portfolio 2, with just a little more volatility added, generated about 11% per year, compared with 10.2% for the least volatile portfolio (1).
  • Adding volatility again will add better returns; in this case, portfolio 4 produced as much as 12% per year.

If you’ve read the digests of previous chapters, you will recall that Van Vliet and de Koning used several metaphors to illustrate their points:

  • The tortoise and the hare.
  • Goldilocks and the porridge that wasn’t too hot and wasn’t too cold.
  • The golden mean (a more formal statement of the Goldilocks metaphor).

So what we have seen in the arc of risk and returns is a golden mean or Goldilocks position: adding some risk to your investment will lead to higher returns, while too much risk will depress them.

And the authors reminded us of what they call the investment paradox, a paradox being something that is seemingly contradictory. And in doing that, they push into the realm of market psychology.

Most of us expect relationships to be straightforward, or linear. That’s what simple rules of thumb give us, and in a complex place like the financial markets, rules of thumb are very handy. Without them, we would be overwhelmed with information that we couldn’t grasp.

The authors don’t go through the litany of psychological conditions now being cataloged and studied under the umbrella of behavioral finance. However, we might add confirmation bias here, which is the human tendency to look for information that strengthens our existing beliefs or theories. Obviously, confirmation bias and paradoxes go hand in hand in this environment.

The sources of our inclination to disbelieve the idea that low- and lower-risk stocks could outperform high- and higher-risk stocks come from a couple of places. First, and as noted in chapter one, it’s the efficient market hypothesis; when you believe that all investors have equal access to all relevant information all the time, then it’s only logical that investors must take on more risk to earn higher returns.

Second, technical analysis leads to the same conclusion because its proponents believe that all we need to know about stocks is encapsulated in their prices (and the patterns those prices make on a stock chart).

Value investors, though, are in a unique position because fundamentals research should show them the sources of risk. A thorough analysis of any company should turn up both quantitative and qualitative information that allows them to understand the volatility that helps drive each company’s stock price. With that knowledge, they should better understand the risk-reward profile on offer among publicly listed corporations.

Conclusion

In this chapter of “High Returns from Low Risk: A Remarkable Stock Market Paradox,” Van Vliet and de Koning have expanded on the research described in the previous chapter. Instead of showing just the returns generated by the least- and the most-volatile portfolios, they also showed the relationship between risk and returns in less extreme positions.

The essential outcome remained the same, lower-risk portfolios outperform higher-risk portfolios because they are less affected by market dips. They win by losing less. Most importantly, though, adding a modest amount of risk to a low-risk portfolio leads to optimal returns.

In the final section, I have tried to put Van Vliet and de Koning’s argument into context, with special emphasis on how value investors should be more attuned to the authors’ work than that of other investors.

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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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