So far, the authors of “High Returns from Low Risk: A Remarkable Stock Market Paradox” have told us why we should invest using their rule of three: low-risk stocks, income generation and price momentum. In addition, Pim Van Vliet and Jan de Koning showed readers how to use a stock screener to select these conservative stocks.
However, what they haven’t told us is what we should do during different phases of the market cycles, if anything. In chapter 14, they write that it is essential to stick to the strategy in good times and bad times. What’s more, success demands a long-term horizon, and we must recognize the different types of markets we will face on the way to that long-term horizon.
Van Vliet has expertise in these matters because he had managed a conservative fund, one made up of stocks that matched the rule of three, between 2006 and 2016. He and co-author de Koning divided market cycles into three phases:
- The bear market, in which prices head down and investors wonder if the losses will ever stop. Some investors experience despair during these periods.
- The moderate market, in which prices rise at a rate of up to 15% per year.
- The strong bull market, which delivers returns of more than 15% per year for conservative stocks and 30% or more for high-risk stocks.
One thing to note here is that a conservative portfolio does not spare investors the experience of being underwater. During bear markets since the Great Depression, conservative investors have suffered during declines. What’s most important is that conservative portfolios lose significantly less than the market-wide average; the low-risk portfolios are typically down by about 5.4%, while overall market prices dropp off by an average of 16.1%.
One of the arguments at the beginning of this book, and a key argument in favor of low-risk stocks, is that they outperform high-risk stocks over the long term because they lose less in tough times. In a sense, it’s not about how far your stocks fall, but how hard it is to recover.
Although bear markets may seem to last forever, they eventually come to an end, often relatively quickly. Still, investors tend to be wary, so they don’t jump back into the market with both feet. This results in a moderate market, in which prices rise as much as 15% per year (but rarely more). During this phase of the cycle, investors with conservative portfolios will, on average, outperform the market as a whole.
However, when the market turns into a bull, you may experience envy for high-risk portfolios. While you’re plugging along with your conservative portfolio, your high-risk colleagues may be making extreme returns—and bragging about it. Not that you shouldn’t be satisfied, since conservative stocks could be bringing in as much as 30% per year, but there are psychological reasons why we can't resist comparing ourselves with others.
Van Vliet and de Koning pointed out that it is during bull markets that conservative investors will be most challenged, as they face the temptation to jump into the high-risk market. Still, the pain should be limited by knowing that momentum is part of their strategy, which increases returns by 3% per year. Most of that 3% comes during bull markets.
For example, 2009 was one of those years. Just months after the carnage of September and October of 2008, the market hit bottom the following March and began a rapid recovery. During 2009, the market returned some 30% while a conservative portfolio would have gained only 8%. Van Vliet writes that he recalled one Chief Financial Officer asking, “Why did we have these conservative stocks in our pension fund last year?”
The “last year” he is referring to was 2009, when the market was recovering. However, in the second half of 2008 and early 2009, he was no doubt very grateful for those low-risk stocks. Van Vliet acknowledges that conservative investing is painful at times because you never get very excited and you often feel regret, “So I can tell you it’s a tough battle.”
Given that difficulty, how do you stick with your conservative strategy? First, Van Vliet and de Koning recommended maintaining a long-term perspective. There are good mathematical reasons for doing so. As they say, you don’t need a century to achieve superior returns; they’re available in just one market cycle (which typically last from seven to eleven years). You can comfort yourself by knowing that even at the end of a bull market, you have likely outperformed over the full cycle.
From their dataset, the authors were able to determine some interesting outcomes:
- In any given year, the market may fall by about 30%, but that is reduced to 10% over five years.
- For conservative stocks, the risk over one year is a third lower, at 20%, which over five years is reduced to just 1%.
Van Vliet and de Koning noted that in this respect, you need less patience with conservative stocks than with average stocks.
Conclusion
Chapter 14 contains answers to two key questions: "How can conservative stocks be expected to fare in three phases of markets? and "How important is it to focus on the long run?"
Conservative stocks did lose money during bear markets between 1929 and 2015, but they still did considerably better than stocks across the market and high-risk stocks. During moderate markets, both conservative and other stocks made money, with conservative portfolios outperforming the non-conservative stocks in general. When bulls ruled the markets, other stocks and especially high-risk stocks outperformed their conservative peers. Nevertheless, over full cycles, conservative stocks took top place.
Van Vliet and de Koning also pointed out the need for patience and a long-term outlook, especially during bull markets. From a risk management perspective, over terms as short as five years, the risk of losing money is much lower than over one year.
Read more here:
- High Returns From Low Risk: Taking the Funds Route
- High Returns From Low Risk: 32 Paradox Stocks
- High Returns From Low Risk: How to Identify the Right Stocks
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