Higher Risk Brings Higher Returns: But Does It Really?
Anyone investing online will be familiar with the accepted truism that taking on more risk is necessary to increase returns. If you invest in gilts or high quality bonds, you will generally earn less than inflation. If you invest in large, mature companies in sectors such as utilities, you can expect low but safe returns. You should move portfolio allocation to these kind of low risk, ‘safe’ assets when you start to become concerned markets are heading for a downturn or your priority is value preservation because you will need to access your capital in the relatively near future. When you want to drive returns and grow the value of a portfolio, higher volatility and risk exposure should be taken on. It’s what we generally accept as the rules of the game.
But is it really the case that higher risk assets provide higher returns? A recent opinion piece in the Financial Times questions the validity of what is generally considered to be one of the cornerstones of investment strategy. The findings of a 2012 study by Robert Haugen and Nardin Barker, “Low Risk Stocks Outperform within All Observable Markets of the World”, are referred to. The study concludes that the reality is, in fact, that the opposite to the accepted truism:
“The fact that low-risk stocks have higher expected returns is a remarkable anomaly in the field of finance. It is remarkable because it is persistent — existing now and as far back in time as we can see. It extends to all equity markets in the world. And finally, it is remarkable because it contradicts the very core of finance: that risk bearing can be expected to produce a reward.”
Quite the assertion. But Haugen and Barker believe they have the data to back it up. The pair’s data set covers the period between 1990 and 2011, spans 21 developed equities markets and risk based on volatility ie. the more volatile a company’s share price, the higher the risk it represents.
The risk to reward ratio rule is formally referred to as the Capital Asset Price Model (CAPM). The accepted reality is that the best performing stocks over the longer term are those which are poorly researched, often because analysts fail to fully grasp the company’s business model and market. Their complexity leads to them being undervalued but over time the company’s fundamentals win out and value increases. But the data compiled by Haugen and Barker indicates that this may, in fact, not be the case.
Author Terry Smith’s review of the study ends with a pertinent quote from Nobel Prize for Physics winner Richard Feynman:
“It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with experiment, it’s wrong.”
Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.
There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.