As far back as 1871, Low Risk Ruled

It's out of fashion, but the classics always come back in style

The Low Risk Anomaly is a tricky one. Everyone seems to admit that it exists, but most investors seem to go out of their way to find reasons not to apply it in their own portfolios, or those of their clients. 

It comes down to human nature, I guess. It’s not enough to win, but you want to look cool doing it. And what’s cooler than owning a portfolio full of the hot stocks everyone is talking about?

I’m well beyond trying to look cool. I’ll take the low risk returns. 

It can be particularly hard holding a portfolio of staid, boring stocks while your neighbor is getting rich gambling on the new paradigm. So allow me to give you another dose of sanity.

Chapter 17 of Low Risk Rules outlines the vast quantity of research supporting the Low Risk Anomaly in investment management - the counterintuitive idea that when investing in the stock market, you can earn higher returns by taking less risk. 

One of the many criticisms of this research is that it results from mining past data to find patterns that fit the desired narrative. As a consequence, it may not persist in the future. 

Well, the research confirming the long-term outperformance of lower risk stocks continues to pile up. 

In 2023, research was published in the Financial Analysts’ Journal, providing further support for the Low Risk Anomaly. [The Low-Risk Effect in Equities: Evidence from Industry Data in an Earlier Time, authored by Conover, Farizo, and Szakmary.]

This research paper pulled data collected from the Cowles all-stock index, collected on NYSE stocks between 1871 and 1938, which is a data set that is out of sample from the existing research highlighted in Low Risk Rules.

The paper confirmed the low-risk anomaly in the Cowles dataset, stating that “low-risk industry portfolios have more favourable performance than higher-risk portfolios. These results confirm that of previous studies where low-risk equities outperform high-risk equities.”

Sorting portfolios by standard deviation, the authors write “it is remarkable how poorly (the highest variability portfolio) performs, with a cumulative alpha that is persistently negative while also being volatile.” 

They go on to say that “the lowest-risk portfolio had the strongest performance, especially on a risk-adjusted basis, with the highest-risk portfolio having the lowest and most volatile returns.” 

In fact, comparing Cowles data with the modern-era dataset, the authors note that “low-volatility investing would have led to an even greater reduction in systematic risk during the Cowles period without any evidence that it would have produced lower realized returns.” 

In Low Risk Rules I wrote that “research across time periods and global markets has proven that you will earn a higher return in low-risk stocks than you will in high-risk stocks. And you will earn this higher return with lower portfolio volatility.” 

This new research paper further validates the existing research. If you’d like to dive in, you can access links to the research papers referenced in the book directly here or see the summary in Chapter 17 of Low Risk Rules, which you can access for free by subscribing to this Substack. 

Hopefully a timely reminder for those of you losing patience with your old school portfolios!