Ha wealth manager, and one of their first tasks will be to determine your attitude to risk. If you don’t know exactly what this means, the questions probably won’t help. They range from the nonsensical (“How do you think a friend who knows you well would describe your attitude toward taking financial risks?”) to the baffling (“Many television programs these days have a hodgepodge of fast-moving images. Do you find this interesting? ; b) irritant; or c) entertaining, but they distract from the message of the program?”). This isn’t necessarily a sign that your new advisor is destined to annoy you. Instead, it points to something fundamental. Risk is at the core of the financial markets. But trying to pinpoint exactly what it is, let alone how much of it you want and what investment choices to pursue, can be maddening.
To get around this, most investors think about volatility instead, which has the advantage of being much easier to define and measure. Volatility describes the spread of outcomes in a bell curve-like probability distribution. Results close to the center are always most likely; Volatility determines how wide a range is considered ‘close’. High volatility also increases the chance of an extreme outcome: in investment terms, a huge profit or a crushing loss. You can measure a stock’s volatility by how wildly it has moved in the past, or, alternatively, how expensive it is to insure it against big jumps in the future.
All of this feels quite risky, even if a nagging doubt remains that real-life concerns lack the symmetry of a bell curve: cross the road carelessly and you risk getting run over; there is no equally probable and correspondingly wonderful advantage. But put aside such doubts, pretend that volatility is a risk, and you can build an entire theory of investing that allows anyone to build portfolios that maximize their returns based on their neuroticism. In 1952, Harry Markowitz did exactly this and later won a Nobel Prize for it. His modern portfolio theory (MPT) is almost certainly the framework your new asset manager uses to translate your risk attitude into a range of investments. The problem is that it’s broken. Because it turns out that a crucial principle of MPT– that taking more risk rewards you with a higher expected return – is not true at all.
Elroy Dimson, Paul Marsh and Mike Staunton, a trio of academics, demonstrate this in UBS‘s Global Investment Returns Yearbook, which has just been updated. They examine the prices of US stocks since 1963 and British ones since 1984, rank them by volatility, and then calculate how the stocks in each part of the distribution have actually performed. For medium and low volatilities, the results are disappointing for proponents MPT: the returns are clustered, with volatility having a barely noticeable effect. It’s even worse for the riskiest stocks. Instead of offering outsized returns, they dramatically underperformed the rest.
The authors of the Yearbook are too thorough to present such results without qualification. For both countries, the riskiest stocks also tended to be those of corporate minnows, which on average accounted for just 7% of the total market value. Conversely, the least risky companies were disproportionately likely to be giants, accounting for 41% and 58% of market value in America and Britain respectively. This reduces the chances of combining a large long position in low volatility stocks with a matching short position in high volatility stocks, which would be the obvious trading strategy to take advantage of the anomaly and arbitrage it away. In any case, short positions are inherently riskier than long positions, so shorting the bounciest stocks on the market would be a tough sell for clients.
Yet it is now clear that no rational investor should buy such stocks, as he can expect to be punished and not rewarded if he takes on more risk. Also, the fact that they were risky is only apparent in retrospect: it is unlikely that the illiquid shares of small companies vulnerable to competition and economic downturns have ever looked much safer. Meanwhile, lower down the risk spectrum, the surprise is that more people don’t realize that the least volatile stocks deliver similar returns at less risk and start seeking them out.
Readers may not be surprised by the conclusion that investors are not entirely rational after all. They may want to take another look at the spicier parts of their portfolios. Perhaps these are the positions that will lead to a gilded retirement. However, history suggests it could be speculation for speculation’s sake. Call it return-free risk.■
Read more from Buttonwood, our financial markets columnist:
Uranium prices are soaring. Investors should be careful (February 28)
Should you put all your savings into stocks? (February 19)
Investing in commodities has become terribly difficult (February 16)
Also: how the Buttonwood column got its name