Making higher risk investments doesn’t always bring greater rewards

One of the first things you're told to consider when you start investing is your attitude to risk. Investors are taught to believe that the greater the risks they are willing to take with their investments, the greater the potential returns they could earn.

This idea is virtually accepted as "an article of faith" in the investment management industry, says Feifei Li of Research Affliates, a US research firm and indeed predates modern finance.

She quotes economist John Stuart Mill, who, in the 19th century, described how the profits of a gunpowder maker "must be considerably greater than the average"to compensate him for the "peculiar risks to which he and his property are constantly exposed".

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While most investors aren't exposed to the same risks as the gunpowder maker, the principle that risk and reward are intimately linked seems unanswerable. And it's often true for example, over the long term, stocks have outperformed bonds, reflecting the lower certainty that they offer. But sometimes it doesn't seem to hold, as is shown by the remarkably persistent "low volatility anomaly".

This rather technical-sounding term refers to the tendency for shares with less volatile prices to outperform those with more volatile ones. Obviously, this doesn't apply to all shares or happen all the time. But on average, low-risk stocks have beaten high-risk ones.

When safety first pays off

The pattern was first spotted by Robert Haugen and James Heins back in the early 1970s. Haugen and Heins found a negative relationship between risk and return in both the US stock and bond markets within each market, the higher the risk, the lower the realised return.

Their results have since been repeated and extended in studies by other researchers. Rather than being a one-off, this effect has persisted across different time periods, in different international markets and has been studied extensively. As such, it seems likely that this will continue and investors aware of it could benefit.

So why do less volatile shares tend to beat their more volatile peers? The immediate reason is that they often trade at a discount to the wider market and to high volatility shares for long periods, says Li.

That's simple enough. But explaining why this happens is harder, since there is no sound financial reason for it. Instead, the most popular explanations revolve around behavioural finance the study of why people make irrational finance decisions.

The bias against boring stocks

One possible explanation is that investors like to "gamble" on risky stocks, because they like the idea of a big pay-off even if it probably won't happen. That drives up the price of high-risk shares to unsustainable levels and depresses less exciting stocks. But taking lottery-like risk in order to deliver higher returns often leads to disappointment hence the less volatile, lower-priced stocks then beat the overpriced risky stocks on average.

According to research by Nicholas Barberis and Ming Huang, investors rationalise their decision to gamble on risky stocks through "probability weighting", believing that low-risk stocks will generate poor returns, and this pattern of behaviour then delivers the opposite effect the low volatility stocks outperform the high-risk stocks.

But high-risk investors who like a punt aren't the only ones at fault here, according to some schools of thought. Supposed sober, professional fund managers also contribute to the effect. Besides picking stocks that outperform, fund managers have other concerns to worry about, such as the fear of losing clients, bonuses or even their job if their fund underperforms its benchmark.

These help drive their decision. They tend to avoid loser stocks, which have dipped in price, because having these in the portfolio could look bad. They may try to minimise the risk of underperforming a benchmark, such as the S&P 500 or the FTSE 100, by turning their funds into "closet trackers" (meaning they hold the most popular stocks in the index their fund).

And the way in which managers are compensated may also play a role, according to research by Haugen and Nardin Baker. Investment managers earn a bonus when their portfolio outperforms, encouraging them to persuade their clients to invest in a higher-volatility portfolio.

Telling a good story

Another even more interesting factor may be the regular investment committee meetings held at investment firms, say Haugen and Baker. Teams of analysts specialising in different sectors present their stock tip ideas to the chief investment officer and want to impress him or her.

Typically, they pick stocks for which they can make a "compelling case" and that feature regularly in the media. These tend to be the more volatile stocks. The fact that these stocks are interesting to talk about also makes it easier for investment managers to explain changes in the portfolio to their clients. All of this creates demand for highly volatile shares, overvaluing them and depressing returns.

Analysts at stockbrokers are also guilty of similar errors. Research by Jason Hsu, Hideaki Kudoh and Toru Yamada found that sell-side analysts have a tendency to hype earnings growth forecasts for high volatility stocks.

On top of this, investors tend to overreact to these overhyped earnings forecasts anyway. This ensures that the market systematically overvalues volatile stocks, ensuring they have further to fall when earnings finally disappoint.

At this point, the rational investor will point out that if everyone catches on to this anomaly and starts buying low volatility stocks, they will rise in price and will cease to offer better returns. Fortunately, not every investor has it in them to become a "heretic" and "disclaim the faith of their fathers" that higher risk equals higher returns, says Li.

Many investors find it hard to stand out from the crowd and hold a contrarian position or even learn from their experiences. That means the outlook for low volatility stocks "remains promising".