5 things I learned from “High Returns from Low Risk”
“High Returns from Low Risk” by Pim van Vliet is the most approachable book on the low volatility stock anomaly. Most investors will tell you that risk and return are two linked parts of investment – a willingness to take more risk delivers higher returns. But is this always the case? Pin van Vliet doesn’t think so, and has built a large and successful funds management business out of his belief that assets that are lower risk deliver higher rewards than investment theory says they should.
The book teaches you how to build low volatility equity portfolios that not only beat the market, but do so at lower levels . Here are five things that I learnt from this excellent book:
1. The average stock has a 20% annual average volatility
Volatility is the degree of price variation. During a typical year, the typical stock has approximately 2/3rds chance of finishing between 20% up and 20% down, and a 1/3rd chance of moving more than this!
Thinking about volatility in this way was a bit counterintuitive, and the results certainly caught me by surprise.
2. The return series used for academic research focuses on single period returns.
van Vliet argues that almost all academic research relies on single time periods, generally one month, to derive their statistical validity. For example, he states that almost all tests of the appropriateness of CAPM rely on testing periods of one month, otherwise “the statistical power would not be sufficient”.
By using single period returns, these studies fail to account for the wonder of compounding, making highly volatile stocks look more attractive and low volatility stocks look less attractive. In fact, when you account for compounding, low volatility stocks trounce high volatility stocks.
3. Why don’t professionals invest like this?
The reason professionals may not be able to take advantage of this anomaly is due to some structural issues with the way the investment management industry works. Simply put, fund managers who deviate too far from their benchmark index are typically deemed uninvestable by investment committees. Yes, people buying the funds want excellent performance, but they also want that performance to look “index-like”, meaning when the index is up 10%, ideally the fund is up 11%.
Low volatility portfolios can have periods of large outperformance and underperformance, but over longer time periods have outperformed. Nonetheless, in investment management, a fund manager is only ever as good as his last quarter (it is precisely as ridiculous as it sounds).
4. Some people simply skip low risk stocks because they are boring.
Quite simply, low risk stocks typically look and act boring! Too many private investors, these stocks lack the excitement of the penny-dreadful that doubles over night due to an exciting iron ore find.
Individual investors tend to buy stocks like they are lottery tickets – they trend towards glamorous, volatile and high risk stocks. Companies in new hot industries or areas of technology are typically found in high risk portfolios, and it is certainly a nice feeling to be able to tell you friends that you bought this stocks when they were floundering minnows.
5. Adding value and momentum to a low-risk strategy turbocharges returns.
The idea of buying cheap stocks is certainly not a new one.
The idea of buying stocks that are showing some positive momentum isn’t either!
It turns out, combining these two things with low volatility stocks typically gets very satisfactory results! For those of you playing at home, I’d encourage you to get the book so you can see exactly how these overlays are implemented. For those of you happy to stick with just low volatility stocks, you will be happy to know that you should see market beating returns over the long term.
When combined with AKO’s book on quality investing, low volatility stocks form the other significant part of my investment screening process. Together, I think these two books, combined with a book on dividends, are potentially the only three one needs to read in order to be able to identify stocks that can deliver attractive, long term returns and income streams.