Low risk stocks give the highest return. Here’s the evidence.
By: Alex Stedman
Tags: Equity, Theory, Stocks, Risk, Investing

Low risk stocks give the highest return. Here’s the evidence.

“If you want to make stellar returns in investing, then you need to take stellar risks”

A familiar conversation had with any investor could go something like this: “Risk vs Reward is a well-trodden path in the investing world, knowing that taking a high risk might get you nothing, but it might also get you that mega-rich payout. If you want a bit of safety with your equity, then go for the low risk stuff but be prepared for some low returns to come along with it.”

This way of thinking is so entrenched in modern portfolio theory that no-one ever questions it or dare ask for evidence. It makes sense, so of course it must be true, right? I’m here to tell you that not only is it not true in the case of equities, but it’s actually the opposite.

“Wait just a second, Alex. You’re telling me that lower risk can actually get me higher returns?”

Yep. Stick with me as I take you through this journey of discovery and Earth-shattering paradigm shift.

Where to start? How about the beginning….

I had to do a bit of digging around to find out where the Risk vs Reward trope came from. It’s re-iterated so much on the internet without reference to the original source that finding it took some serious searching. It turns out the answer was buried in an academic paper I have saved in my cloud BUT the point remains! Like a Trump tweet refusing to stop its spread around the world, the Risk vs Reward argument will be defended to the death by commentators in all corners of the internet without a shred of evidence being offered.

The academic paper which I’m regurgitating here for you now is Baker & Haugen, ‘Low Risk Stocks Outperform within All Observable Markets of the World’, published April 2012 and can be found at http://ssrn.com/abstract=2055431 .

It all goes back to those haughty decades of the 1960s and 70s, when almost everything was being turned on its head, both politically and culturally (I can’t speak from experience, I must add!). The foundations of modern finance theory were being laid, and in the case of Risk vs Reward, the Capital Asset Pricing Model and Efficient Market Hypothesis were the main drivers. Trillions of dollars were moved from equities to capitalisation-weighted indices; the trouble with the theory was that it apparently had a few holes in it. A 1972 working paper by Haugen and Heins exposed these deficiencies and showed that reward actually had a *negative* relationship to risk, but these findings were excised in the review process, and the final paper was published without them in 1975. The flawed portfolio theory was in full swing and no-one was going to stop it, evidence be damned.

Here’s the truly strange thing about this piece of work, though – the Haugen and Heins findings weren’t an anomaly. Studies finding the same results were published by Jagannathan and Ma (2003), Haugen and Baker (1991), Blitz and van Vliet (2007 & 2012), Ang, Hodrick, Xing and Zhang (2006 & 2009) and Carvalho, Xiao and Moulon (2012). All come to the same conclusion; that lower risk equities not only do not provide lower returns than their higher-risk counterparts, but actually swing the relationship on its head and find the best returns are achieved from the lowest-risk stocks. (Maybe I’m a bit late in the article to point this out, but ‘risk’ here is defined as the volatility in the trading price of an equity.)

OK, show me the goods

The following cross plot is lifted directly from the 2012 Baker & Haugen paper mentioned above. They took all equity stocks in 21 developed countries and 12 emerging markets every month over the 21 years from 1990 to 2011, including what they call ‘non-survivors’ (ie failed businesses). That’s quite an extensive range. (The Haugen and Heins paper that had its results excised covered years 1921 to 1971. All the papers, when taken together, are an embarrassment of evidence covering nearly 100 years and almost the entire globe)

Return vs Risk, lowest risk decile & highest risk decile

You don’t need to be a trained economist or data scientist to see the trend here. Far from being the expected positive trend between risk and reward, there is an *obvious* negative trend over this set of data analysed by Baker and Haugen.

Outside the sphere of investment banking, in the world of academia and retail finance, people are starting to realise that the risk-reward dogma might be flawed. With the internet being such a great resource for easily-accessible information, blogs and professional publications are starting to ask questions. I performed a quick search of ‘risk vs reward’ and within the first few pages of results were a couple of sites that quesitoned the traditional risk-reward way of thinking. Kurtis Hemmeling over at Seeking Alpha performed his own analysis of the S&P500 and published his results here – https://seekingalpha.com/article/4108577-high-risk-high-reward-think-again

High beta stocks vs S&P500

Mr Hemmeling writes “…it leads to the question about whether the connection between risk and return is really true. Are investors rewarded for taking on extra risk? Can we automatically say that portfolios which outperform the market are riskier? Or do we have a case for market mispricing?”. In case that wasn’t enough, he summarises his findings with

“My studies show that higher risk results in lower returns.”

At this point I feel like I’m a broken record, but I also feel like I need to really hammer this home because, clearly, the messsage hasn’t got through in the past 55 years. I encourage you to read the paper by Baker & Haugen I linked to earlier; it’s a good read, you don’t need a degree in finance to understand it, and they provide some additional insights in to why risky assets are priced so high (with a savage takedown of analysts and portfolio managers).

So next time you’re at a dinner party and someone says their high-risk portfolio of stocks is the best strategy to higher returns, you can really kill the mood by pointing out to them that they’ve been duped. Just promise me you’ll tell them nicely.