[The Low-Risk-Effect, also known as the Low-Volatility Anomaly has a brief Wiki entry Low-Volatility-Anomaly you may want to visit if the subject is new for you.]
Trillions of dollars are invested based on a model we now know, with near certainty, is in large part incorrect. I’m referring to the Capital Asset Pricing Model (CAPM), an intuitive lattice of assumptions that’s been fraying for some time.
Chief among its intuitive, but proven beyond nearly all reasonable doubt wrong, assumptions is the notion that higher risk produces higher rewards. Actually, and counterintuitively, it doesn’t.
The trillions of dollars are managed by folk who’d prefer this reality not be too widely advertised. School fees, AUM attraction and not a few inflated ego’s are supported by the CAPM so, understandably, there’s been push-back to studies that have revealed it to be a bit, er, wrong.
One objection to the critical work on risk-return has been because studies have used the same dataset (from The Center for Research in Security Prices, CRSP), conclusions have been ‘data mined’ i.e. biased researchers went and found what they were looking for.
What would be helpful therefore would be to find this same low-risk-higher-return effect in an equally detailed dataset from a different period and source. The paper highlighted today, from C. Mitchell Conover (et al.) from the University of Richmond, does just this.
I won’t waste more of the casual reader’s time as the argument in detail is for wonks and interested practitioners only and they can follow it more fully via this link The Low-Risk Effect*.
[*The link will get you to the Financial Analysts Journal where the paper was published. If you’re not a CFA Institute Member you may be able to create an account to access. Failing that drop me a line and I’ll send you, direct and tout suite, a PDF copy.]
The merely curious only need know this. High risk stocks do well when markets are doing well, but that’s about the only time they work out. Even at such times low risk stocks often outperform and, crucially, they reliably outperform in all other conditions.
The reality therefore of investing (in stocks at least, but almost certainly the case in many other asset classes for the same reasons) is higher risk does not lead to higher returns. Counterintuitive, but true nonetheless.
Happy Sunday.