Pim Van Vliet’s book High Returns from Low Risk examines the investment paradox that the lowest risk stocks (measured by volatility) outperform the highest risk stocks over the long term. This phenomenon has been established across markets and eras. The book builds on the work of Eric Falkenstein in The Missing Risk Premium and his paper on risk and return at SSRN.
According to the deans of finance, this should not be the case. For instance, the Capital Asset Pricing Model (CAPM) assumes a linear relationship between risk and reward. But of course this does not represent the real world.
“Bearing higher risk generally produces higher returns. The market has to set things up to look like that’ll be the case; if it didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.”
— Howard Marks
So You’re Telling Me There Is a Free Lunch?
The following diagram shows a frown whereby risk increases return up to a point, but the highest risk stocks underperform the lower risk stocks. You should take some risk, but not too much.
Valuation Still Matters
Since the low risk anomaly has been identified, several ETFs such as USMV & SPLV have been created to exploit it. In recent years, a lot of hot money has chased the strategy and driven up the prices of low volatility stocks. The observation of the phenomenon has changed it.
So returns from low risk may be somewhat muted going forward until the excitement fades and the hot money moves on to chase something else. As in any other investment strategy, valuation matters, and you should seek a margin of safety.
Why The Anomaly Should Persist Longer Term
So we see that the low risk anomaly exists. But why should it exist, let alone persist? For ordinary investors, the main reason is the pull of the possible lottery ticket payoff from exciting, high risk stocks. It is a lot easier to brag about owning Tesla or Nvidia than it is about owning Johnson & Johnson or a regulated utility. And as the popularity of lotteries shows, people are blind to probabilities when they can fixate on a potential huge payoff. Low risk stocks just don’t have the same visceral appeal, so they tend to be avoided as if they are only appropriate for widows and orphans.
“Our desire to impress others causes us to take too much risk.”
— Eric Falkenstein
For institutional money managers, the reasons the low risk anomaly should persist are incentives and short term comparison periods. Professional money managers don’t pursue absolute returns with low risk because it can cause wildly different short term returns than their benchmarks. They are measured and compensated based on their performance versus these benchmarks over short time periods, not over complete market cycles. If they neglect the horserace, they will likely be fired. Thus, they avoid low risk stocks, leaving a juicy opportunity for investors with a long term orientation and a lack of fear of being different than the crowd.
“Suppose a stock always generates gains of 10% a year, while the market varies between -40% and +60%. How risky is this stock from a relative perspective? Sometimes it lags the market by 50% and sometimes it performs 50% better than the market. From a relative risk perspective, the steady stock is very risky. From an absolute perspective, there’s no risk at all because every year you earn 10% with no volatility. … Professional investors have to focus on relative risk to prove to their bosses, clients, and others that their performance is above average.”
— Pim Van Vliet
Additionally, professional money managers tend to gravitate toward complexity because of self preservation in terms of marketing. It is hard to sell a strategy where they are just buying boring low risk stocks and hanging on. Average people might figure they could do that. Why would they need to pay someone else 1% a year to do it for them? So I think this is another reason the pros will continue to avoid low risk stocks and go for the complicated and high risk stocks that tend to baffle the average guy.
Low Risk Outperforms in Bear Markets, but Lags In Bull Markets
While low risk stocks tend to outperform in a bear market, it can be difficult to hang on during a bull market when you are likely to lag. The sense that everyone else is getting rich can be hard to take without capitulating. Persistence over an entire market cycle is needed to get the outperformance the low risk strategy can deliver.
“The low volatility portfolio wins by losing less during times of stress.”
— Pim Van Vliet
Low Risk Is Better For Long Term Compounding
Van Vliet also shows that there is an additional cost to the investor in high risk stocks due to compounding effects. Compounding causes big losses to have an outsized negative impact on long term performance. The smoother ride of a low risk stock portfolio leads to a much bigger pile of money in the long run, because it doesn’t interrupt the magic of compounding with big losses.
“The longer your investment horizon, the greater extent to which risk will hurt your long-term returns through compounding effects. For a high-risk portfolio this difference is more than 6% per year.”
— Pim Van Vliet
Low Risk Helps Retirees and Near Retirees
A potential bear market is a huge risk for people in or near retirement. A big loss at that time of life can put a huge permanent dent in their lifestyle. A cash cushion and a bond allocation should be considered, but a substantial allocation to stocks is still needed because of lengthening lifespans. Low risk stocks fit the bill in this regard as well.
“For older investors, conservative stocks are more attractive than all stocks, as they have less time to recoup any portfolio losses they have experienced.”
— Pim Van Vliet
An Antidote to Financial Noise and Unnecessary Complexity
Pim Van Vliet’s book is a breath of fresh air. That one can ignore all of the noise and succeed with low risk stocks is a blessing for the individual investor, if he is willing to put in the work and can stand to be different from the crowd. I am perfectly happy ignoring the horserace and earning high returns with low risk.
I love to find boring, cash cow companies that it is hard to brag about owning. Sacrificing your ego for financial gain can be emotionally counterintuitive, but lucrative. I would much rather have the cash register ring reliably than have bragging rights.
This book functions as an antidote to all of the noise in the blogosphere from financial pros hating on simple strategies such as investing in dividend paying stocks. For one example, see Dividend Stocks Are The Worst by Meb Faber.
I’m sure Meb is a good guy and he is smart as heck. His shareholder yield strategy (dividends plus buybacks) has a lot of strengths, but it also has weaknesses.
While he has pointed out the drag from taxes owed on dividends, I would point out that qualified dividends are only taxed at 15% in the 25% federal bracket. In the 10% & 15% brackets, the tax rate for qualified dividends is 0%. In an IRA or 401(k), taxes are deferred. And in a Roth, dividends are tax free.
In a bull market shareholder yield will likely beat the pants off of a dividend strategy. But the problem with buybacks is that they occur most during a boom when stock prices are high, and they get shut off during a recession when stocks are cheap. An awful lot of companies destroyed value by buying back a bunch of stock in the 2002-2007 bull market, only to reissue it at much lower prices in the aftermath of the financial crisis.
We could go back and forth all day long, but to me it is a matter of personal preference and goals. My goal is not to beat the market, but to comfortably afford the life I want to live. Pim Van Vliet shows that a low risk strategy can even outperform. I may beat the market without even really striving to do so. And I certainly won’t fire myself if I am 50 basis points shy of the S&P 500’s total return.
A Dividend Oriented Strategy Beats Dollar Cost Averaging In Reverse in Retirement
Another substantial benefit of the dividend growth strategy over the “living off of the pile” strategy promoted by most of the financial industry is that it is perfect for turning a portfolio into a stream of income during retirement.
This solves a major weakness in the mainstream advice to gradually sell off part of your portfolio every year in retirement. Dollar cost averaging in reverse destroys value just as dollar cost averaging in the accumulation phase creates value. A low risk, dividend growth strategy is simply much more practical in the real world for real people than trying to live off of the pile.
And the smoother ride of investing in largely defensive, low risk stocks with secure and growing dividends means that I won’t panic and sell during a downturn. The key is that I believe in it, and I know it will get me to my goals if I stick with it. That is much more than good enough for me.
“The great strategy you can’t stick with is obviously vastly inferior to the very good strategy you can stick with.”
— Cliff Asness
“Humility means loving the truth more than oneself.”
— Andre Comte-Sponville