Putting a low-risk investment plan to work

How to think about building your low risk portfolio

Over the past several weeks I have explained my criticisms of index-based, passive, and factor-driven investment strategies.

But there’s something glaringly, obviously wrong with my endorsement of the low-risk anomaly, and I’m sure that “evidence based” academic finance practitioners are shaking their fists at me and calling me a hypocrite.

You see, the low-risk anomaly is itself an academic finance construct—derived from decades of study and observation. And it’s been tested by using rigid, academic finance–based rules. And sure, an automated, rules-based approach is a fine way to implement a low-risk investing strategy. But I don’t think it’s the best way to implement a low-risk investing strategy.

Why do I say this?

Recall that market anomalies are ephemeral. The more easily they can be replicated, the more likely they are to stop working. As with any anomaly, once we try to turn a low-risk strategy into a set of rigid trading rules, it can be easily replicated and could thereby lose its effectiveness over time.

So the first problem is that I need to define “low risk,” which the research does by defining it in terms of volatility. This is necessary because empirical study requires an objective and consistent risk measurement that can be used across different markets.

There is an obvious problem with this, and if you’ve been following along you already know what it is.

It comes down to the definition of risk. More specifically, your definition of risk.

Here it is: volatility is not risk!

To be clear, volatility is risk to the extent that it can throw you off your investment plan by forcing you into mistakes. But stock price volatility, in and of itself, is lying to you. Volatility in itself is not a risk to a long-term fundamental investor (that’s you!). Your risk measure is preserving your purchasing power over time, not any academic definition of risk.

OK—so if low risk isn’t necessarily low volatility, how should we define it?

I’ve said it before, and I’ll say it again: you are building your portfolio out of businesses, not stocks. Let the academic finance guys define low-risk stocks as those that exhibit low price volatility. That’s fine. While they are building portfolios out of stocks, we will build empires out of businesses.

So, how to define low-risk businesses?

As I have implored you to do, let’s carry your business skills into the investment realm. What is a low-risk investment? Think like a businessperson. Forget price volatility. A low-risk business would have consistent cash flows. Pricing power. Low debt. It’s selling an essential product or service to a diversified customer base. It has some sort of sustainable advantage over its competitors, in a business with high barriers to entry.

If you were designing a business from scratch with a primary goal of protecting your wealth, think of the characteristics you’d like your business to have. Invest in companies that share those defensive characteristics.

Now you’ve got a portfolio of low-risk businesses. And here’s where we tie it all together with a bow. It just so happens that companies exhibiting these defensive, low-risk characteristics also tend to have lower price volatility and lower beta, also fitting into the academic “low risk” bucket. Not always, but usually. And so your “low-risk business” empire will end up looking a lot like a “low-risk stock” portfolio.

This is why I can feel comfortable leaning on the academic research, and extrapolating it through to a fundamental bottom-up portfolio of businesses.

So, what are the key differences between my approach, and that favoured by the academic finance crew?

First, you’ll own fewer businesses, because there are only so many that your portfolio manager can keep on top of and understand. An academic strategy, on the other hand, sees stocks as commodities and will hold hundreds or thousands of different names. The benefit to you is that you’ll have a better understanding of what your money manager owns in your account, which will help you maintain conviction in the strategy.

Second, you may end up owning a few businesses that the market perceives as higher risk, but that your portfolio manager understands to be lower risk. This is the essence of value investing—identifying a situation where Mr. Market misunderstands the true value of an underlying business. This allows a skilled money manager to add value to your portfolio over time… by stocking up on “lower risk” situations which the market incorrectly perceives are “higher risk.”

As you can tell, this value approach entails the use of judgment. Variable skill (and luck!) levels between managers mean that you can’t automate the process and can’t rely on the consistency of the results. Some investors may find this unacceptable, but my contention is that investing relies on human behavior and will therefore always be an art, not a science. Investors must be comfortable with uncertainty.

Besides, strictly rules-based approaches come with their own problems. Sometimes they cause you to take risks you didn’t necessarily intend to take. For example, passive value strategies often emphasize measures like book value, which could lead to a heavy allocation to banks and insurance companies, which may not always be appropriate (it’s why many value funds did poorly in the 2008/09 mortgage crisis). Low-priced value stocks may also carry low prices for a reason—that is, their business is struggling, or in a dying industry, or the company has been mismanaged. Cyclical companies also appear to be cheap at the top of a business cycle, and buying them based simply on a low P/E ratio, as an automated value strategy might, can be dangerous.

Similarly, low-volatility funds rely on a series of rules to qualify stocks for the portfolio that are based on historical observed volatility, which may not match the volatility we see in the future. Worse, as this strategy becomes more or less popular over time, the performance can actually be impacted by fund flows in and out of stocks that exhibit these trading characteristics.

In plain English, this means that decisions other investors are making can turn low-volatility stocks into high-volatility stocks over time, which might offset any of the benefits you’re trying to achieve.

Unfortunately, the quest for a passive, low-cost, rules-based approach to investing often leads to these kinds of dead ends. Because markets are dynamic, you can’t really switch your portfolio onto autopilot and ignore what’s going on around you. You need someone watching the road ahead.

For all of these reasons, I believe that it’s far better to build a portfolio made up of low-risk businesses than just focus on stocks that exhibit low-volatility characteristics. The end result may behave similarly, but you can have far more confidence in the implementation, and thereby have more conviction in your portfolio.

I believe that by creating a portfolio of low-risk businesses, which as a group exhibit the characteristics of a low-volatility portfolio (but individually may not), you are getting the best of all worlds.

That’s a winning low-risk approach.