In chapters six and seven of “High Returns from Low Risk: A Remarkable Stock Market Paradox”, authors Pim Van Vliet and Jan de Koning look more deeply into risk. It’s all part of their thesis that, as the title claims, you don’t have to buy high-risk stocks to earn above-average returns.
In fact, they show that you’re far better off investing in low-risk stocks because in the long run, they will outperform high-risk stocks. That’s the investing paradox referenced in their subtitle.
But investors, academics and analysts will only see the advantage of low-risk stocks if they analyze returns over years or decades, and not months. In chapter five, they demonstrated how high-risk stocks have an advantage when evaluated on a month-to-month basis. The difference between the two sets of results is that low-risk stocks lose less in the inevitable market downturns and that compounding becomes a factor in the long run.
Van Vliet and de Koning wanted to alert their readers to a different kind of paradox; one of perspective. Van Vliet reported he first became aware of it when he left academia in 2005 and went to work at an investment firm. The downside risk of equities had been the subject of his Ph.D. thesis, and he was anxious to apply the findings from his research in the quantitative research department.
As he advocated his ideas, Van Vliet was told his theory about low-risk stocks and high returns wouldn’t be accepted because people who work in the industry have a different perspective on risk. Specifically, they have “an almost obsessive need to benchmark the performance of investment managers.”
What the investment industry taught Van Vliet was the difference between relative risk and absolute risk:
- Relative risk refers not to the loss of money, but the risk of lagging the market, doing worse than other investment managers or missing their benchmarks. This obviously refers to the universe of fund managers, whose jobs depend on not succumbing to any of the above problems.
- Absolute risk refers to the loss of money or capital, the simple risk that individual investors try to minimize.
Put simply, professional investors have to justify their performance to their bosses and their clients, and are judged on how well they did relative to a benchmark or other target. For example, many institutional money managers are measured against their ability to outperform their benchmarks.
The clients of the professionals share that perspective. They’re not just looking at the returns, they’re comparing them with returns produced by other investment managers. And, they often take a short-term view.
Van Vliet and de Koning offered the example of a manager who finds a perfect stock with a guaranteed return of 10% per year. However, the market goes up 30% in year one and down by 7% in the following year. In the first year, the manager lagged the market by 20%, so no bonus for her or him. In the second year, the market goes down 7% and the manager beats it by 17%. However, from a relative perspective, they are only making up for the previous year’s underperformance. So that perfect stock with a guaranteed 10% return is considered very risky and unattractive.
It’s important to note that individual investors are not handcuffed by the same relative risk constraints. They can work in a world of absolute risk and take advantage of the investment paradox.
Chapter seven does an interesting follow-up on chapter six. Titled, “The Dark Appeal of Risk,” it explained that individual investors could pursue a low-risk, high-return strategy, but many often don’t take it. They find a high-risk strategy more satisfying.
The authors began with a few remarks about jealousy and envy, and the idea of “keeping up with the Joneses.” They also referenced author Eric Falkenstein, who pointed out that using a relative-risk framework would stimulate envy, and envy is a powerful emotion that can influence investment decisions.
That’s not the only reason individual investors fail to find the paradox of low risks and high returns. They may not know about the value of compounding or haven’t linked it to their investing; they don’t see professional managers taking advantage of the paradox; and, quite simply, many individual investors don’t want low-risk stocks because high-risk stocks are more appealing.
The latter group, investors buying and selling for their own accounts, buy what they think is attractive. As Van Vliet and de Koning put it, they buy stocks as if they’re buying lottery tickets, chasing volatile, sexy and headline-grabbing stocks.
Among their favorites are stocks that possess “exciting new business models in exciting new industries.” Long-term considerations are set aside as they focus on how these companies might grow and how their stock prices might rise. Not surprisingly, such an approach can lead to bubbles; the South Sea Bubble of 18th century England, for example. Among its victims was the scientist Sir Isaac Newton, who wrote that he could figure out the movements of stars but not the madness of men.
Consequently, we see both professional managers and many individual investors chasing high-risk stocks—betting on the hare and against the tortoise, to use one of the authors’ metaphors—leaving low-risk stocks overlooked.
This opens the door to other investors, especially value investors who want unpopular stocks and bargain prices. Van Vliet and de Koning argued that other investors need only change their perspective on risk from relative to absolute and to stop comparing themselves with other investors. From a positive perspective, focus on absolute risk and long-term capital growth, remember the importance of compounding and be patient.
Conclusion
In chapters six and seven of “High Returns from Low Risk: A Remarkable Stock Market Paradox,” authors Van Vliet and de Koning explained the difference between relative and absolute risk. Relative risk is about investors, whether professional or amateurs, comparing themselves with others. It means trying to beat benchmarks or the performance of others. Absolute risk refers to the potential of losing money.
Those who follow a relative risk strategy lose out on the investment paradox, on the finding that low-risk stocks deliver higher returns than high-risk stocks—over time. The authors have listed numerous reasons why the relative risk strategy is so widespread, including constraints placed on professional managers and the “stocks as lottery tickets” approach by amateur or individual investors.
Finally, it’s important to note that this approach, by the majority, creates opportunities for the minority, for those who have an absolute risk perspective. When low-risk stocks are neglected, they will be available at prices even value investors will appreciate.
Read more here:
- High Returns From Low Risk: Compounding and Time Horizons
- High Returns From Low Risk: Goldilocks for Investors
- High Returns From Low Risk: The Paradox Explained
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