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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.
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“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.
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.
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“The low volatility portfolio wins by losing less during times of stress.”
— 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 very lucrative. I would much rather have the cash register ring reliably than have bragging rights.
To me it is a matter of personal preference and goals. My goal is 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.
A Dividend Oriented Strategy Beats Dollar Cost Averaging In Reverse in Retirement
While a low volatility strategy and a dividend oriented strategy are not precisely the same, I believe they are close cousins. A 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.
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“The great strategy you can’t stick with is obviously vastly inferior to the very good strategy you can stick with.”
— Cliff Asness
See also:
DR 167: Interview of Josh Peters of Morningstar March 18, 2015: Soundcloud and Transcript
Mohnish Pabrai Lecture at UCI, 6-7-17 — Few Bets, Big Bets, Infrequent Bets
Is the staggeringly profitable business of scientific publishing bad for science?
“Humility means loving the truth more than oneself.”
— Andre Comte-Sponville
Zone of Competence 