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Robert Abbott
Robert Abbott
Articles (795)  | Author's Website |

High Returns From Low Risk: Compounding and Time Horizons

Short-term and non-compounding returns explain why research on the investment paradox is slim

January 27, 2020

Pim Van Vliet and Jan de Koning, the authors of “High Returns from Low Risk: A Remarkable Stock Market Paradox,” began chapter five by wondering why other researchers hadn’t discovered what Van Vliet did: that low-risk portfolios will outperform high-risk portfolios over time.

In his view, researchers, and especially academic researchers, still believe there is a linear, positive relationship between risk and reward, that greater risk should reap greater rewards. And, he asked why research hasn’t yet debunked that relationship.

The authors concluded that it was a matter of time horizons because academics were researching returns in the short term, say months, while Van Vliet focused on long-term returns measured in years or decades. Once those long periods come into play, so does compounding.

When talking about compounding, the authors naturally point out this involves getting returns on previous returns, since it is assumed all dividends and capital gains are reinvested in the original company or stock. In studying monthly returns, compounding is not enough to make any significant difference.

And, claimed Van Vliet and de Koning, monthly returns are what are used in most academic studies. They attributed that to research on the capital asset pricing model, which assumes a positive, linear relationship between systematic volatility and returns. When CAPM is tested, they argued, researchers need to deal with periods of one month, because they wouldn’t have enough statistical power otherwise.

Serious investors, though, have a time horizon of multiple years or even decades. So monthly returns may be convenient for researchers, but don’t speak to the needs of many investors.

The authors then asked, what would happen if they took compounding out of the mix and assessed the returns from Van Vliet's dataset in terms of simple monthly returns? They returned to the 10 portfolios described in chapter four (the 1,000 stocks in the dataset were ranked by risk and put into 10 groups, with one being the lowest risk and 10 being the highest risk).

This time, they looked at one-month simple returns with no compounding. The results are shown in this table by the authors:

As Van Vliet and de Koning noted, the paradox becomes less clear when simple returns are involved; since high-risk returns outperform in short-term results, the paradox would not be visible in that case. There is, of course, the exception in both the simple and compounded returns for portfolio 10, the highest-risk group.

But to the broader point, researchers would not see the paradox if they work only with simple, short-term returns. One person who did see the paradox early on was Robert Haugen, an American professor of finance, whom the authors referred to as the man who discovered the investment paradox. It was his article in 1975 that alerted Van Vliet to it.

This investment paradox occurs not only in the United States, but in other countries as well. The authors reported that empirical evidence of it has been found in European and Japanese stocks, as well as those in the emerging markets of China, Brazil and South Africa. They have also found evidence of it within every industry sector, and they added that once they became aware of it, they were finding it everywhere.

For investors, then, high-risk portfolios may be alright on something like a month-to-month basis, but as time horizons stretch forward there is a sea change. The longer the investment horizon, the more risk will harm long-term returns because of lost compounding.

About Haugen

Given that Haugen discovered (or at least was the first to promote the idea that low-risk stocks could outperform high-risk stocks), I thought it worthwhile to add a bit of information about him.

Haugen, born in 1942 and died in 2013, was an academic financial economist and professor. Along with one of his former professors, A. James Heins, he published “On the Evidence Supporting the Existence of Risk Premiums in the Capital Market” in 1972 and “Risk and the Rate of Return on Financial Assets: Some Old Wine in New Bottles” in 1975.

He was a prolific writer with several important articles and books to his credit, including “The New Finance: The Case Against Efficient Markets” in 1998. This book was required reading for the chartered financial analysis exam. Throughout his work, he has been a leader in challenging the ideas of the efficient market hypothesis and the capital asset pricing model.

Over the course of his career, he held professorships at the University of Wisconsin, the University of Illinois and the University of California. Later, he started a consulting business, Haugen Custom Financial Systems, and lectured globally.

Conclusion

In chapter five, Van Vliet and de Koning asked why the paradox wasn’t better known and embraced among other researchers, especially academic researchers.

They concluded that it was because most researchers focus on short-term returns, not those available in longer terms. Short-term results are simple and non-compounded, giving them a conventional risk and return profile in which higher risk is generally rewarded with higher returns. In this context, it’s worth remembering that most serious investors do invest for the long term and look to compounding to increase their wealth.

Finally, I briefly surveyed the career of Haugen (and his colleague, A. James Heins), who is credited with being the father of low-risk investing and a leading critic of EMH and CAPM.

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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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