Risk, Return, and Investment Fads

Do low-risk stocks have higher returns?

Photo: Chamomile. Source: Morguefile

That’s what a lot of people are thinking. It’s kind of counter-intuitive. After all, it’s always been taught that in order to get returns, you have to take some risk. Bonds are more risky than bank deposits, but they pay more. Long-term bonds are more risky than short-term bonds. Stocks are more risky than bonds—their prices are more volatile, and if a company goes bust, stock investors usually don’t get anything back. For example, when after the financial crisis, investors who owned Lehman’s shares were wiped out, while those who owned senior Lehman’s senior debt received around 30 cents on the dollar. That’s not a lot, but it’s a whole lot better than nothing.

The assumption that risk and return are linked is central to much of modern finance. It is assumed that your total investment returns are generally limited by your risk tolerance. In fact, this has become a central tenet in most asset-mangers’ education. You won’t pass the CFA curriculum if you put a risk-averse 100% into stocks. The theoretical foundation of this practical norm is the Capital Asset Pricing Model, first formulated by Bill Sharpe in 1964. He won the Nobel Prize in Economics for his insight.

But academics began documenting anomalies to the CAPM almost as soon as it was proposed. They discovered a “size effect,” a “quality effect,” and a “value effect.” These factors capture the fact that small companies, well-run companies, and cheap stocks tend to do better than the general market. Lately researchers have been looking at a “low-volatility” effect—the notion that stocks where the price doesn’t jump around as much seem to do better than shares of jumpy firms. This turns risk/return thinking on its head. If the “low-vol” effect is right, then the least risky stocks are better investments—more return for less risk.

Source: Eric Falkenstein, “Finding Alpha

The financial industry has capitalized on this notion, creating a host of low-vol funds and ETFs. These appear to be pretty successful. The five largest funds have almost $40 billion in assets under management, gathering $25 billion in the last two years. Year-to-date, they have returned over 11%, while the S&P 500 is up only 8%.

But on further examination, much of the low-vol effect turns out to come from other factors. High-volatility stocks historically have been penny stocks and the most speculative shares. Penny stock marketing was reformed in the early ‘90s, and when the tech bubble burst, a lot of non-income “concept companies” went away.

Lately, low-volatility stocks have done well, but much of that can be attributed to the recent outperformance of dividend-growth companies like utilities, consumer products firms, and pharmaceutical corporations. Since bonds don’t pay much—if anything—any more, income-oriented investors have shifted their funds from bonds to stocks, pushing the prices of dividend-growth stocks to record levels. The PE ratio of the Dow Jones Select Dividend Index is now 37% above its average level.

Source: Bloomberg

Financial fads come and go. In the late ‘90s it was tech stocks. Before the financial crisis it was China. Now it’s dividend growth. Investors rush into a concept and rush right back out again, leaving disappointment and disillusionment in their wake. Technology and China and dividends remain important investment themes, but not at any price. If you pay too much for anything, your performance will suffer.

In a portfolio, as with clothes, fashion is what you’re offered. But style is what you choose.

Douglas R. Tengdin, CFA

Chief Investment Officer

By | 2017-07-17T12:21:46+00:00 August 22nd, 2016|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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