This book revolves around what Pim Van Vliet and Jan de Koning called an “investment paradox,” that low-risk stocks outperform high-risk stocks over time. But that doesn’t necessarily apply to all low-risk stocks.
Previously, the authors argued that just putting together a portfolio of such stocks might be OK, but it wouldn’t lead to the best performance. No, it would take two additional factors. First, choosing stocks that can deliver “income” from dividends or buybacks (and based on value-investing criteria). And second, that these stocks have momentum, i.e., their prices are rising steadily.
To prove their argument, the authors went back to the dataset and analysis introduced in chapter three. Now, in chapter nine of “High Returns From Low Risk: A Remarkable Stock Market Paradox,” they were reworking their spreadsheet.
Once again, they worked with a dataset that contained the monthly closing prices of all American stocks between Jan. 1, 1926 and Dec. 31, 2014. Each year, they selected the 1,000 largest (by market cap) and ranked them according to their volatility. Previously, they compared the 100 most volatile and 100 least volatile.
This time, they’re staying with the ranked group, but simply dividing them into two groups: the 500 most volatile and the 500 least volatile. They discarded the 500 most volatile, leaving them with the 500 least volatile (least-risky) stocks.
Of the 500 that shared a low-volatility ranking, not all had income or positive momentum. Some did, but there were many combinations, including those that had high income but poor momentum, and those that had exactly the opposite characteristics.
To deal with these anomalies, they redid the rankings. First, they ranked all 500 by income; second, they ranked them by momentum. Each stock received a score between 1 and 500 on each list, and the scores were averaged. Thus, a stock might get a score of 1 for income, but a score of 500 for momentum, resulting in a final score of 250.
The “best” stocks enjoyed low volatility, high income and good momentum, and they were called “conservative” stocks. Van Vliet and de Koning then theoretically bought the 100 stocks with the best combined score and referred to them as their “conservative portfolio.”
They used the term “conservative” because the formula gives more weight to companies that conservatively allocate their assets, preferring to return money to shareholders rather than spend it themselves. Second, it is also conservative in terms of timing because the stocks are only chosen when investors begin to bid up their prices.
Now, to the results:
- Overall, Van Vliet and de Koning refer to a “superior” and “very attractive” portfolio, as in “The portfolio is characterized by very attractive returns during the 1929-to-2015 period.”
- Even after just a few years, the conservative portfolio is pulling ahead.
- By 2015, the conservative portfolio is worth $21 million, which is 53 times the worth of the original low-volatility portfolio (500 stocks).
What’s happening of course is that the lowest-risk portfolio is suffering fewer losses, thus allowing it compound faster. It’s the win-by-not-losing strategy.
In a follow-up, Van Vliet used the same procedure to work with the 500 highest-volatility stocks that had been discarded for the first part of the test. This produced a “bad” or “risky” portfolio that contained 100 stocks that were most volatile, had no or little income and had poor or no momentum. The result?
- The original $100 invested in 1926 was worth just over $750 at the end of 2014, compared to the $21 million generated by the conservative portfolio.
- The average annual return for this portfolio is about 3%, compared with 15% for the conservative portfolio.
That’s certainly a disappointing return after 86 years in the market. It became a devastating return when inflation was factored into the results. Van Vliet and de Koning noted that $100 in 1929 had the same purchasing power as $1,373 in 2015. Put another way, the risky portfolio lost money when inflation is considered, and its net loss would have been $723 ($1,373 - $750 - $100).
As this chart by the authors shows, the conservative portfolio beat the risk portfolio in every decade and did not lose in any of them:
An important question is raised at this point by the authors: Do their returns have statistical significance? Overwhelmingly, they report. Given the difference of 12% per year average, there is a one in one quintillion chance the results are not sheer luck.
They also took on one other comparison: How would the conservative portfolio compare with the average of the stock market (a benchmark)?
- The conservative portfolio generated an average annual return that was 4% greater than the benchmark—at a lower level of risk.
- When compounding is factored in, the conservative portfolio generated $21 million, while the conservative portfolio produced $870,000.
Conclusion
In chapter eight of “High Returns From Low Risk: A Remarkable Stock Market Paradox,” Van Vliet and de Koning made a theoretical case for their three-part strategy. It involved selecting low-volatility stocks with high incomes and growing momentum. In chapter nine, they put meat on the bones of their case by describing the research underlying the premise.
That research made clear that this strategy worked very well, outperforming both a portfolio with low volatility but little income or momentum and a stock-market-as-a-whole portfolio.
Once again, the secret to this strategy is to avoid or minimize losses so your compounding can be as strong and consistent as possible.
Read more here:
- High Returns From Low Risk: Income and Momentum
- High Returns From Low Risk: 2 Perspectives on Risk
- High Returns From Low Risk: Compounding and Time Horizons
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