High Returns From Low Risk: Is the Investment Paradox Really True?

In their book, “High Returns From Low Risk: A Remarkable Stock Market Paradox,” Pim Van Vliet and Jan de Koning have made a case for their investing paradox. However, does that idea of low-risk stocks outperforming high-risk stocks apply in other countries and to other securities? Will it continue to work in the future?

The authors used chapters 16 and 17 to answer those questions. They wanted to begin by offering other examples of the paradox, to refute the idea that their backtesting was insufficient to prove the point.

According to the authors, financial leverage was one form of proof. Companies with higher leverage are inherently riskier because of the possibility they may default - that’s not a risk among companies with no debt. Studies showed that stocks with higher leverage generated below-average returns.

The evidence also showed that the investment paradox prevails on stock markets in other countries; that included a study by Robert Haugen, whom the authors credit with discovering the paradox. They also cited a study that showed that low-risk stocks have outperformed high-risk stocks on the Belgian stock market since 1873.

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In another take, Van Vliet and a colleague put together a global database and determined that cyclical sectors do not produce better returns than the lower-risk defensive sectors. A study by Huij found the paradox applied to mutual funds, as funds that invested in low-risk stocks outperformed those that did not.

Turning to other asset classes, the authors pointed out that investors demand higher returns for longer-term (riskier) bonds than short-term bonds. That’s logical and intuitive because more things can go wrong over longer terms, and longer-term bonds are also more sensitive to rising interest rates.

Bond-rating firms routinely grade bonds according to their credit risk. Riskier bonds, often called high-yield or “junk” bonds, have lower ratings than low-risk bonds, and thus they have to offer a higher premium. The authors cited research by a colleague who found that low-risk bonds have higher risk-adjusted returns, so the paradox applies there as well.

The same holds for commodities and derivatives (stock options), where lower risks lead to higher returns; for example, gold (which is more conservative) outperforms natural gas (less conservative) over time. As Van Vliet and de Koning noted, there is evidence of a negative relationship between risk and return.

Look away from investing and toward speculation markets, they found the paradox held in lottery tickets, gambling and horse races. The authors pointed to a phenomenon known as “long-shot” bias, which is the tendency among gamblers to prefer low-probability, high-payout bets like lottery tickets. On the horse-racing front, a study by Snowberg and Wolfers found that the average horse-racing bet lost 23%, while the riskiest, long-shot bets lost an average of 61%. Even here, low risk “outperforms” high risk.

Despite all that, Van Vliet and de Koning insisted that the goal when investing should not be the total elimination of risk. Instead, investors should look for what Aristotle called the golden mean, which is also known as the Goldilocks solution—not too hot and not too cold. They wrote, “So within virtually all markets, risk is not rewarded. However, across the two asset classes of bonds and equities there is a modest reward for risk.”

Their rule of thumb is als follows: "Avoid all securities that look like lottery tickets or offer very high returns. Within that context, it is possible to increase wealth by taking on a bit of limited risk in the bond and equity markets."

In chapter 17, Van Vliet and de Koning asked whether the paradox would persist in the future. For example, what would happen if everyone suddenly started buying conservative stocks? Investing history tells us that many strategies work very well for a time, but then stop working, perhaps because of changes in the market cycle or other factors.

To develop their point that it would survive, they divided the argument into three conditions that needed to be met: "See It," "Be Able to Profit from It" and "Be Willing to Do It:"

• See it: An increasing number of investors should be learning about the paradox because of an increasing number of studies and low-risk mutual funds. Of course, if all investors learn about the paradox, it would theoretically disappear.
• Be able to profit from it: While many investors might learn about it, a significant number of them will be investing through managed or index funds. Van Vliet and de Koning reported that a large and increasing piece of the market is owned through collective investment schemes (including pension funds and sovereign funds). Portfolio managers are paid to takes risks rather than reduce them. With conservative stocks being shunned by fund managers, the number of paradox strategy users is likely to be limited. At the same time, an increasing amount of capital is going into passive indexes, and most of that capital will not be using this strategy (the exception to this would be funds based on low-risk securities).
• Be willing to do it: Knowing about the paradox and being able to profit from it are not enough in themselves to make all investors into low-risk investors. Many invest for the thrills as much as the profits, so many investors will ignore the paradox and just keep buying lottery-ticket equities. The paradox also demands patience, which as we know is not always a trait among long-shot investors.

Conclusion

In chapters 16 and 17, Van Vliet and de Koning demonstrated that the paradox is all around us, and that low-risk securities of many kinds outperform high-risk securities. Not only can it be found in the stock markets of other countries, but also in history and even in gaming.

Will the paradox continue to work in the future? It's likely. After all, the three conditions necessary to make its use widespread aren’t likely to change much. More people may learn about it, but few will be able to use it and even fewer might be willing to use it.

Read more here:

• High Returns From Low Risk: Don't Trip Yourself
• High Returns From Low Risk: This Is What Happens During Market Cycles
• High Returns From Low Risk: Taking the Funds Route

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