In their book, “High Returns From Low Risk: A Remarkable Stock Market Paradox,” authors Pim Van Vliet and Jan de Koning have made the case that buying low-risk stocks is the key to investment success. Thanks to time and compounding, low-risk stocks (also known as low-volatility stocks) outperform high-risk stocks quite handily.
So is buying a basket of low-risk stocks enough to financially secure your future? “No,” say the authors. Creating such a portfolio is a just a starting point; you can’t buy just any stock that is low risk.
As Van Vliet and de Koning pointed out, you might see satisfying results, but its also possible you might be giving up a fortune. As they put it, your recipe needs two additional ingredients: income and momentum.
Income
To begin with something obvious, you cannot buy every low-risk stock since that would leave you with an enormous portfolio. So how do you trim down that universe?
Here, the authors introduced value investing and its emphasis on buying stocks that are on sale. That is, their market prices are cheap compared to the company’s intrinsic value (and intrinsic value is based on its fundamentals). Find stocks that temporarily go out of favor with the market, buy them when their prices are depressed and hold them until their popularity returns (or hold them for the long term to make the most of compounding).
That still leaves a large field of stocks. Van Vliet and de Koning ask us now to think about the purpose of buying stocks, which, of course, is to get something in return. That means a capital gain if the price goes above the purchase price, or a dividend. They place a lot of emphasis on dividends, citing research by Elroy Dimson that found about half of the total return in the U.S. and U.K. stock markets, between 1900 and 2000, was from dividends.
Not all companies pay dividends, but some do buy back shares. The authors reported that buybacks also represent income to shareholders, because profits will be divided among fewer shareholders. They used the word “income” to designate all proceeds from buybacks and dividends. There’s another aspect they brought to our attention, too: When stock prices go up, income yield will decline and vice versa. So if we watch yields, we have another indicator on valuations.
To do well with low-risk stocks, investors also need to prune or avoid stocks that are cheap for a reason, ones that look good on the surface but have bad fundamentals. These are called “value traps,” and essentially the name says it all. They appear to have good foundations, but are really full of termites.
Momentum
In addition to good value investing characteristics, Van Vliet and de Koning like stocks that have momentum. According to them, momentum will keep you from buying into value traps. This means incorporating price trend information into the overall analysis.
Price trend is the idea that stocks moving up will continue to keep rising in the near future, while those on the decline will continue to slide. This is a concept from technical analysts, who have a simple mantra: “The trend is your friend.” According to the authors, there is robust academic evidence supporting the practice of momentum investing.
They reported that investors tend to underreact to news for about a year. Also, over short periods (a month or less) and for periods longer than three years, investors tend to overreact to news. Thus, in periods of less than a year, investors don’t recognize how well or how poorly a company is doing. One of the ways of overcoming this bias is to practice momentum investing.
Van Vliet and de Koning go on to note that momentum also will help investors select stocks that are “on the verge of recovering to their intrinsic value at the right time.” I can understand there might be some value in what the authors are saying here, but would add that if the stock is approaching its intrinsic value, it’s no longer a value stock.
Further, they add that if you don’t have the patience to buy stable, high-income stocks, you should only buy those exhibiting what they call “appealing momentum.” Again, I find this somewhat contradictory since it seemingly suggests that it’s OK to ignore the fundamentals of a stock if it is growing quickly. That sounds more like speculating than investing.
Finally, they argue that momentum and income make a powerful pair, allowing you to buy the right stock at the right moment. However, are there many stocks that exhibit these virtues at the same time? Presumably, the authors think there are.
Conclusion
In chapter eight of “High Returns From Low Risk: A Remarkable Stock Market Paradox,” Van Vliet and de Koning have advised their readers that buying any basket of low-risk stocks is not enough by itself. To ensure better returns on a sustainable basis, investors need to add two additional ingredients.
The first is income, based on either dividends or buybacks, and the process begins by finding stocks that are bargains, selling for less than their intrinsic value. The second is momentum, which refers to buying stocks that have been trending upward and should continue in that direction.
I have a couple of reservations with the momentum section because it seemed that momentum and income could easily conflict: Can you have both momentum and value approaches at the same time, without them negating each other?
Read more here:
- High Returns From Low Risk: 2 Perspectives on Risk
- High Returns From Low Risk: Compounding and Time Horizons
- High Returns From Low Risk: Goldilocks for Investors
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