For as long as people have been investing in the stock market, they have been told that with the expectation of higher returns should come the expectation of higher risk. So, it’s not surprising that many investors think high-risk, high-volatility stocks will outperform lower-risk stocks over time. However, in reality, less-risky stocks have outperformed riskier stocks and the stock market consistently over time. It may be time for investors seeking superior long-term returns to rethink that return-risk relationship of stocks.
Research going back to Nobel Laureate William Sharpe in the 1960s says that future returns are related to risk. However, while that relationship supports investing across major asset classes — i.e., stocks outperform bonds, bonds outperform cash, etc. — it doesn’t necessarily support the returns of individual stocks. Research has shown that low-risk or low beta (volatility) stocks outperform high-risk stocks.
The Allure Of Over-Priced, High-Volatility Stocks
According to the efficient markets hypothesis, the stock market is thought to be highly efficient. If that’s so, why do low-risk stocks consistently outperform high-risk stocks? Could it be that investors tend to overvalue the more exciting “headline” stocks, opting for a slight chance of hitting it big? Early investors in Google and Amazon generated great returns on relatively small investments. Investors looking for the next Google or Amazon seem willing to overpay and drive up valuations of companies with similar characteristics.
That might explain why investors will flock to a company that’s growing at 20% even if that growth is already priced into the stock. It shouldn’t be a shock to them then if the stock drops extensively when the company reports lower results, which is often the case. However, if you invest in a company growing at 10% while the market expects just 5% growth, the stock will likely fare much better.
It’s A Race Of The Hare Vs. The Turtle
While it’s true that low-volatility stocks produce nowhere near the outsized returns of risky, high-volatile stocks in sharply rising markets, they also tend to fall less when the market declines. It’s that downside protection that explains why low-volatility stocks can outperform high-volatility stocks over time. Over the long term, the negative impact of losses to investment returns can far outweigh the positive impact of gains.
In research comparing the total returns of the least volatile stocks to the most volatile stocks from 1990 to 2011, the least volatile stocks consistently outperformed the most volatile. The researchers, Nardin L. Baker and Robert A. Haugen, explain how high-volatility stocks are attractive to professional money managers who are under pressure to dress up their portfolios with market-leading headline stocks to please their shareholders. This not only drives up valuations but also exposes their portfolios to more significant downside risk.
In a more recent study, S&P Global found that the S&P 500 Quality index, made up of companies with strong returns on equity and low volatility, not only provides greater downside protection than the S&P 500 index but also outperforms during periods of extreme volatility. From the record highs on February 19, 2020, to April 15, 2020, the S&P 500 fell 18%. During the same period, the S&P 500 Quality index fell by less than 15%.
People Don’t Want Boring Stocks
The other reason low-risk stocks outperform is they are boring. The allure of headline stocks and the market’s big daily gainers draws attention from low-key stocks, which are underrepresented, for example, in the growth portfolios of many mutual funds. Mutual fund managers need to deliver for their end investors by beating their benchmarks, so they might load up on a few high-flyers hoping one of them pays off.
Meanwhile, this avoidance of boring companies by some retail and professional investors has the effect of suppressing their stock prices. This is true even for many high-quality companies that deliver consistent returns and grow shareholder value. They’re just not exciting enough to own. Investors don’t see the risk story in high-quality companies, so they don’t see the return potential. As a result, investors will underpay for a quality company that will continue to grow its intrinsic worth over time.
Boring Is Better For Long-Term Investors
Quality companies are typically well-established with strong brands and a competitive advantage in growing industries. They’re known for generating predictable earnings growth regardless of economic conditions. They’re financially stable with solid balance sheets, which makes it much less likely they’ll run into financial trouble. Most importantly, they operate at the highest levels of management efficiency, enabling them to generate sustainable earnings and free cash flow that can be compounded over time. That is the key to attractive long-term returns.
Boring? Yes, investing in low-volatility, quality companies might not get your adrenaline pumping. But that shouldn’t be the objective of a long-term investment strategy. Protecting your downside while compounding your returns, in the long run, should be.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.