The Unexpected Evidence That Lowering Your Risk Actually Improves Your Investment Returns

It flies in the face of traditional financial theory. Still, study after study suggests that avoiding risky stocks can often improve your risk-adjusted investment returns.

Recently, researchers at the Stern School Of Business and AQR Capital Management have reviewed the evidence. They find that lower risk stocks tend to come out ahead on a risk-adjusted basis.

What Low-Risk Investing Means

There are numerous strategies under the umbrella of low-risk investing. You can buy stocks that have tend to be less volatile, or move less with the overall markets. You can also invest in more stable stocks with more stable earnings or fatter margins and healthier balance sheets. However, regardless of the measure chosen, the researchers find that higher quality stocks tend to outperform over time on a risk-adjusted basis.

Return Without The Risk

In a sense, this is a puzzle compared to traditional financial theory. Generally, if you are taking on greater risk with your money, you would expected a higher expected return. Though, that’s not the pattern the data shows.

Breaking The Rules

Historic data suggest that markets aren’t necessarily following the rules, or at least not enough compensation is provided for the level risk. Essentially, taking on risk may get you a slightly higher return, but the extra return generally isn’t worth it for the risk involved.

Imagine an upward sloping line, giving you more return as you ratchet up your investing risk. The reality isn’t that simple. In fact, that line appears to be fairly flat. As you increase your risk, yes, your returns become more volatile and less predictable, but they don’t increase your returns as much as you would expect. You aren’t necessarily getting rewarded for the sleepless nights that a risky portfolio might entail. Dialing back your portfolio risk may actually be a free lunch.

Not Foolproof

Needless to say, the strategy is not without risk. Even though returns have historically been robust for lower risk strategies, there have been periods of clear drawdowns such as 1931-32, 1998-1999 and 2008-2009. The study ended prior to the spring 2020 market decline, so there’s no analysis of that period. So it’s no silver bullet, but can be a way to finesse your portfolio.

Implementation

The message then is that risk is generally best avoided. The market does not reward you for it as you might expect. Yes, you can still enjoy superior returns buy owning stocks, but you don’t necessarily need to own risky stocks to achieve the best returns.

How It Stacks Up

Also, this isn’t just an oddball theory. It holds up against some of the more traditional factors that investors more commonly focus on. For example, focusing on lower risk investing has returns that aren’t too different from a strategy like value investing running data back to the 1930s. In fact, there’s only one factor that’s noticeably ahead of the low-risk strategy, and that’s momentum, which means owning stocks with better short-term price performance.

Annual Returns

Implementation of a lower risk strategy, depending on the method used, has historical delivered additional returns of around 2% to 10% a year, on average, based on history. That’s top of the underlying returns to stock investing that we’ve seen historically. As such low risk investing has the potentially to enhance long-term returns considerably if history is any guide.

Of course, with any factor-based strategy there’s no guarantee that the future follows the pattern of the past. Still, the evidence is quite compelling that saddling your portfolio with additional risk, isn’t necessarily a way to boost your investment returns.

Playing it safe, may both help the risk and return of your portfolio. That’s not what financial theory might suggest, but it is what historic data shows.

Published at Sun, 10 Jan 2021 23:24:44 +0000

By Editor