U.S. Markets closed

High Returns From Low Risk: An Investing Paradox

Many market participants believe in the efficient market hypothesis, which holds that all relevant market information is available to all market players at the same time. Therefore, everyone ought to earn average returns. One of the direct implications arising out of that idea is that investors can only achieve above-average returns by taking on higher risks.

Other investors, however, know that can't be entirely true because they've seen evidence to the contrary, especially among the many famed value investors who rose to the top of the stock-picking universe. Most notably, we have seen Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) lead Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) to lofty heights with an entirely different set of principles.


In their book, "High Returns from Low Risk: A Remarkable Stock Market Paradox," Pim Van Vliet, Ph.D. and Jan De Koning, CFA charge head-on against the hypothesis. As the title suggests, they see a paradox: low-risk portfolios will outperform high-risk portfolios.

Both authors work for the Dutch international asset manager Robeco. According to the firm's website, Van Vliet is the founder and fund manager of the Conservative Equity funds, as well as a guest lecturer at several universities. His co-author, de Koning, is the manager of the Core Quant Equities fund.

The authors emphasized the idea of paradox in the introduction and chapter one, which they call "the modern market equivalent of 'the tortoise and the hare.'" They argued that investors make decisions without enough statistical evidence. Thus, they proposed more use of "evidence-based" investing, which is to use well-tested investment theories about portfolio creation.

They also refer to the law of diminishing returns. Van Vliet and de Koning illustrated this law with sports and cooking metaphors; for example, "the first 100 hours of training has more value than the second 100 hours," and so on down the line. "When cooking, the first pinch of salt will enhance the flavor, but beyond the first few pinches, adding more will detract from the flavor."

Generally, we look for a golden mean of not too much and not too little. Aristotle explained the concept of the golden mean quite extensively, but many of us are more likely to recall the Goldilocks business of finding the bowl of porridge that wasn't too hot and wasn't too cold.

The law of diminishing demand and the golden mean were used to help them make the point that too much of something can lead to the opposite effect of what was desired. "A paradox," they wrote, "is anything that appears to be contradictory in nature."

According to Van Vliet, he discovered what he considered to be the biggest paradox in the investing world: that low-risk stocks could generate high returns and high-risk stocks could produce low returns.

That discovery came while reading a 1975 article by Robert Haugen as an undergraduate student. Later, as a Ph.D. student, he went back to the idea and studied it further and found new evidence confirming it. A few years later, in the early 2000s, he joined an international investment company. After a couple of years with the firm, he was able to start his own low-risk fund in 2006.

During his early months at Robeco, he was struck by the way that the concept of risk was backward. That is, the investment industry was not treating risk as a matter of losing money, but as a matter of underperforming a benchmark. He felt that that perspective was wrong, but more importantly that it might also explain the investment paradox.

Van Vliet noted that they managed to convince a lot of investors that they could profit from this misperception of risk. As a result, Conservative Equity became a $15 billion (USD) fund family and now has localized funds in multiple countries and regions.

Beyond the book, on the Robeco website, Van Vliet and David Blitz, the firm's manager of quantitative research, recently issued a paper that follows up on the low-risk, high-return concept. Among their findings were the following:

  • They were able to reaffirm that high-risk stocks don't outperform low-risk stocks. Interestingly, they noted that the evidence of this was first reported during empirical tests of the Capital Asset Pricing Model (CAPM).
  • There is a direct link between risk and volatility (the standard deviation of returns), and according to the authors of the study, volatility is the main driver of the low-risk effect. They found this phenomenon persistent over time as well as across markets, sectors and market-capitalization sizes.



Conclusion

Vliet and Koning set out to argue that not only is the concept of high-risk, high return wrong, but that the opposite is true. Low-risk investing can and does lead to high returns, while high-risk investing is likely to lead to low returns.

That's the central paradox they pose to readers, that you will become a better investor by sticking to low-risk assets. Van Vliet was able to use knowledge of this paradox as the foundation for a family of mutual funds, all based on low-risk investing.

Finally, my thanks to GuruFocus reader Henry (chinhoufu) for bringing this book to my attention.

Read more here:

  • Value Investing: What Makes Great Investors Great?
  • Value Investing: Risk Issues
  • Value Investing: About the Stock Market



Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.